Effects of Worker Reclassification

The IRS has the power to reclassify workers that an employer treats as independent contractors as employees.

The reclassification of an independent contractor as an employee has possible consequences both to the employer and to the reclassified workers and to other employees.

Consequences to the reclassified worker:

• The worker may become eligible for benefits that he was not receiving.
• The worker is no longer liable for self-employment taxes.
• The worker becomes liable for Social Security and Medicare taxes which are imposed at a lower rate than are self-employment taxes.
• The may be entitled for a refund of self-employment taxes for all open years.
• The worker loses the ability to deduct business expenses on Schedule C.
• Unreimbursed employee business expenses are now deducted on Schedule A subject to the two percent floor.
• The change from deducting business expenses on Schedule C to Schedule A can result in an increase in adjusted gross income which may affect the taxpayer’s eligibility for credits, such as the credit for child and dependent care credit and the child tax credit and possibly other tax benefits.
• There is an increased possibility that the taxpayer will become subject to alternative minimum tax since employee business expenses are a tax preference item and are not deductible in computing the alternative minimum tax.
• If the worker has not filed a tax return for the year(s) for which the reclassification applies, he must file a return reporting the 1099-MISC income as wages and must pay the employee portion of Social Security and Medicare taxes which are reported on Form 4137. (Scratch out “Tips” and insert “Wages” on Form 4137.)
• If a tax return has been filed for the year(s) affected by the classification, the worker must file form 1040X, (a) computing the differences between self-employment taxes paid and the Social Security and Medicare tax owed, (b) removing any deductions claimed as a self-employed taxpayer on Schedule C, (c ) claiming any allowable employee business expenses on Schedule A, and (d) making all other changes as necessary.

Consequences to the employer and other employees:

• The employer must pay all the taxes that should have been paid under the income tax and Social Security and Medicare tax withholding provisions. The code specifically includes withholding taxes that the employer should have withheld, although the rate is possibly lower than what it would have been if the worker had been classified as an employee.
• The employer must issue corrected W-2 and 1099 for the year(s) of reclassification.
• The employer will have to evaluate all of his benefits plans to determine the consequences of the reclassification.
• The employer may face possible claims and litigation from the reclassified employees.
• The reclassification could result in the disqualification of the employer’s qualified retirement plan. If the plan called for benefits for all employees and the reclassified employees had not been afforded those benefits, IRS may determine the plan had not been operated according to the plan’s own rules. The treatment of additional, often non-highly compensated, workes as employees may cause the plan to fail a number of tests that depend on the number and ratio of highly compensated to non-highly compensated employees, including the non-discrimination, coverage, and participation tests.
• Failing to have included the reclassified employees in a group health plan, a cafeteria plan, an education assistance plan, or a dependent care assistance program may requite other employees to hav to include in their income the benefits they have received if those plans are found to be discriminatory.
• A stock option plan may be found to be discriminatory because it did not include the reclassified workers which may result in the stock option plan to be classified by IRS as discriminatory. If so, all of the participants under that plan may face additional taxes on their exercises of their stock options. The employer may be allowed additional payroll deductions but would be faced with additional employment taxes since they were neither withheld nor paid when the stock was purchased.
• Reclassified workers may seek benefits which they have not received in the past under ERISA.


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LORIN BROWNING

Licensed by US Department of Treasury as Enrolled Agent
Licensed by SC Board of Accountancy as Accounting Practitioner

Web site: www.lorinbrowning.com
E-mail to: lorin@lorinbrowning.