Tax Articles

Doing the Cleanup When a Client Loses Independent Contractor Status

New IRS Guidance

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At a recent IRS National Phone Forum, an IRS representative said that "one of the biggest tax challenges for companies is determining whether workers are employees or independent contractors." He might have added that the employee/independent contractor issue can also be a challenge for the workers (and their tax return preparers) -- especially when you have to help with taking care of the reclassification.

Changes Moving Forward

If the IRS determines that a client has incorrectly classified as an independent contractor instead of an employee, there are a number of consequences. For example, the client no longer is responsible for making estimated tax payments to cover the income and self-employment tax due on his or her compensation. Instead, taxes will be withheld from the client's newly classified wages and the client will have to file a Form W-4 to make sure the proper amount is withheld. And the client will not be filing a Schedule C to report self-employment income and deduct expenses; the wages will be reported on Line 7 of Form 1040 and the expenses will be claimed as a miscellaneous itemized deduction (subject to the 2% of adjusted-gross-income threshold).

Cleaning up the Mess in Prior Years

However, while the employee label might not present much of a headache for a client going forward, there is the problem of cleaning up the mess left behind in prior tax years because of the client's incorrect classification as an independent contractor.

The IRS recently issued revised guidance about what individuals should do when they are moved from independent contractor status to employee status [Notice 989, Rev. 7-2009].

Different Scenarios Raise Different Issues

How painful the process will be depends to some extent on whether the individual is a long-time client who has been keeping up to date on his or her tax duties as an independent contractor or whether the individual is a new client who has been remiss on these duties and is now suddenly confronted with a reclassification notice.

Here is what the IRS says must be done for prior years.

• If no tax return was filed. The client must file Form 1040 for the affected tax year(s), reporting the Form 1099-MISC income reported to by the employer as wages on line 7. Since no Social Security or Medicare tax (FICA tax) was withheld from these wages, the employee portion of these taxes must be computed and paid with the return. For tax years prior to 2007, Form 4137, Social Security and Medicare Tax on Unreported Tip Income, is used to compute FICA tax and ensure that the client receives credit for this income with the Social Security Administration (SSA). For 2007 and later, Form 8919, Uncollected Social Security and Medicare Tax on Wages, is used.

Note. The IRS accepts Form 4137 for years prior to 2007 to compute the employee's portion of FICA tax on income not treated by the employer as wages. When filing Form 4137, cross out the word "TIP(S)" and replace it with the word "WAGE(S)". Form 4137 and a copy of the IRS reclassification determination letter should be attached to the return. Beginning in 2007, individuals whose employment status is in dispute or who have been determined to be employees by IRS can use Form 8919 to calculate FICA tax on the income that has been determined to be wages.

• If a return was filed but Form 1099-MISC income was not reported. The client must file an amended return on Form 1040X for the affected tax year(s) to include the additional income as wages and re-compute federal income. The client's portion of FICA tax must also be computed for this income. Again, for tax years prior to 2007, use Form 4137; for 2007 and later, use Form 8919.
• If Form 1099-Misc income was reported but no FICA or self-employment tax was computed and paid. The client must file Form 1040X for the affected tax year(s) to compute the FICA tax due on this income, using either Form 4137 or Form 8919.
• If Form 1099-Misc income was reported and self-employment tax was computed and paid. The client must file Form 1040X for the affected tax year(s). The employee is not subject to self-employment tax, but still must compute and pay the employee portion of FICA, using Form 4137 or Form 8919.
• If Form 1099-Misc income was reported and FICA tax was computed and paid. The client may not need to file an amended return (but see "Schedule C and Schedule SE" below).

Note. An employer may voluntarily pay the employee portion of the client's FICA tax. If a client receives a corrected Form W-2 that shows this payment and the client has already paid the FICA tax, he or she can file Form 1040X to request a refund. However, the employer's payment of the client's FICA becomes additional income in the year paid.

Notes on Proper Use of Forms to Set Things Right

Schedule C and Schedule SE

If a client is reclassified as an employee, Schedule C of Form 1040 cannot be used to report income since wages earned by an employee are reported on line 7 of Form 1040. The client must file Form 1040X to reflect the correct amount of tax owed as an employee.

When a client's income on an original return was reduced by expenses, the change to employee status may increase the client's tax because he or she will now compute FICA tax on gross wages instead of computing self-employment tax on net income on Schedule SE. Furthermore, the expenses deducted from income on Schedule C must now be deducted as miscellaneous itemized deductions on Schedule A, subject to the 2%-of-adjusted-gross income threshold.  

Moreover, some expenses may no longer be deductible. Self-employed individuals are allowed a deduction on Form 1040 in an amount equal to one-half of self-employment tax. As an employee, the client loses this deduction and any other deductions allowed because of self-employment status (e.g., the self-employed health insurance deduction and the deduction for contributions to a Keogh-type retirement plan).

Whether a client will be entitled to a refund or owe extra tax will depend on the net impact of the changes on the amended return. These changes include:

1. The amount of FICA tax owed compared to the self-employment tax originally paid.
2. Whether or not any of the business expenses originally reported on Schedule C can be transferred to Schedule A, Form 1040 as miscellaneous expenses.
3. The removal of deductions the client was entitled to as a self-employed individual, such as the deduction for one-half of the self-employment tax.
4. Changes (increase or decrease) to any tax or credit computed on adjusted gross income such as the alternative minimum tax, earned income credit, or credit for child and dependent care expenses. Changes mentioned in 1 through 3 affect adjusted gross income and/or taxable income.

No W-2

If the client did not receive a Form W-2 from his or her employer for the affected year(s), or the amount on the Form W-2 received was incorrect and the client has not been successful in obtaining a correct one from the employer, the client can file Form 4852, Substitute for Form W-2, Wage and Tax Statement, or Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. and use it as a substitute for Form W-2 to send with the amended return(s). The income should be estimated as closely as possible if the client does not have evidence of the actual amounts paid.

Outstanding Liabilities

The IRS may have billed a client for taxes that will be affected by the reclassification, such as an underpayment of self-employment tax. The IRS will continue to send these bills until an amended return is filed.

The reclassification will not stop the billing process. When an amended return has been processed, the tax liability and any interest or penalty charges will be changed as appropriate. Once an amended return is filed, you or the client should inform the IRS office that has been sending the bills that an amended return has been filed.

If a client is currently paying taxes on an installment plan and the reclassification will affect the liability, the client should continue making payments until an amended return has been processed and the client is notified by IRS whether there is any balance due.

We have prepared a letter that you can send to clients alerting them to the tax ramifications of their employment status (see following).

The IRS says the client may also contact IRS Customer Service at 1-800-829-1040. An IRS representative can assist by contacting the employer on the client's behalf. The letter that the employer receives will advise him or her of the employer's responsibilities to provide a correct reporting form and the penalties for failure to do so.

Reach Out to Clients

So you can reach out to clients or prospects on this issue, we've prepared a brief introduction and invitation that you can print to letterhead or paste into an email to your clients.

The introduction is in the form of Microsoft Word document. Download to your computer to save and modify as appropriate.

• Dear Client Facing Reclassification (Word doc., 33 KB)

Terence M. Myers, J.D. and Dorinda D. DeScherer, J.D. are nationally renowned writers on tax topics for such publications as Accountants Tax Weekly, Tax Return Preparer's Letter, Nonprofit Tax and Financial Strategies, and Executive's Tax and Management Report. For many years Myers was Managing Editor and DeScherer Assistant Managing Editor for many Prentice Hall tax newsletters. Myers and DeScherer have published books and other publications with Harcourt Professional Publishing, Aspen Publishers, Prentice Hall, and the AICPA.

Last Updated: 09/04/2009