Worker Classification and S Corporations
Segal, Mark A., The CPA Journal
Tapayers and the IRS have long battled over whether a worker is an employee or an independent contractor. Typically, the IRS asserts that the worker is an employee, whereas the employer asserts that the worker is an independent contractor.
The tax stakes involved in these disputes concern the following:
Identification of the party responsible for remitting certain tax obligations. Where the worker is deemed an employee, tax payments related to compensation come from regular deposits composed of amounts withheld from the worker's paycheck as well as a component of employer matching. In contrast, if the worker is deemed an independent contractor, earnings will be reported on the worker's Schedule C. Should the Schedule C show positive net income, the worker will be obligated to pay self-- employment tax (Schedule SE). The self-employment tax contains both the employee and employer components of FICA and FUTA. Note that individual taxpayers are allowed to deduct one-half of self-employment tax (which represents the employer match).
The amount to be remitted. Allowing the worker to report income and related deductions on Schedule C enhances the possibility that the self-employment tax will be less than the amount of taxes that would have been remitted if the worker were deemed an employee.
Failure to property classify a worker may result in substantial penalties. Potential penalties arise from a variety of sources (e.g., IRC sections 3509, 6302, 6651, 6656, 6662, 6672, and 6673). These include penalties for failure to file timely returns, whose amounts escalate rapidly depending on the delinquent amounts, and assessments of willful or fraudulent intent to evade taxes.
Common-Law Employee Test
Classification of a worker as an independent contractor or employee is generally determined pursuant to a common-- law employee test. All relevant facts and circumstances must be examined in light of the 20 factors provided in Revenue Ruling 87-41, 1987-1, CB 296. Exceptions to strict application of this test exist in certain IRC sections and the safe harbor provisions of Section 530 of the 1978 Revenue Act.
Recent cases have addressed certain unique aspects of the tax treatment of items related to worker status. In Cleveland Indians (87 AFTR2d Par. 2001-- 798), back pay awarded to baseball players in a settlement agreement was found subject to FICA and FUTA taxes under the rules applicable to the year the award was paid, rather than the rules applicable to the year the amount should have been paid. In North Dakota State University (87 AFTR2d 2001-1036), nonacquiescence by the IRS, amounts paid to tenured faculty for early retirement were held not subject to FICA because they were received for a property right (tenure rights) and not as compensation. In contrast, amounts paid to tenured administrators for early retirement were held subject to FICA.
Other fact patterns of note in this area concern employee leasing. In this regard, Microsoft had a group of workers originally classified by it as temporary, freelance independent contractors reclassified as common-law employees, despite the following facts:
*They wore different badges than regular full-time employees.
*They were not invited to com pany functions.
*They were specifically informed that they would not be subject to withholding or benefits.
*They signed an agreement that indicated they were to be considered independent contractors and would need to provide their own insurance and benefits.
Subsequently, the workers were still found to be employees of Microsoft despite the use of a temporary agency as an intermediary between the worker and Microsoft (for background, see the cases of Vizcaino v. Microsoft).
S Corporation Issues
S corporations have long held appeal as a means to mitigate FICA and FUTA obl gations. Use of an S corporation for this purpose is premised on the following:
* The S corporation is a pass-through entity. …