1099-Misc workers are retroactively reclassified as Employees

[SFA]

Ok, I am sure this is not the first time this topic has been raised, but I need some fresh thinking . . .

 

I have a new client who has contacted me as a result of an unemployment audit raised after a 1099-Misc worker was severed and applied for unemployment benefits.

 

The result is a reclassification of almost all of their 1099-Misc workers. For unemployment they are now employees, and the business owner is being assessed for delinquent returns going back to 2010.

 

What is the correct way to handle the "wages" that have been paid to these "employees" since January of 2014, as well as prior years? 1099-Misc statements were filed. Must those be amended and replaced with recalculated W-2's?

 

The business has never had "employees" before and is now applying for an EIN, and registering with the various taxing authorities (state and local withholding).

 

Since this was a state unemployment audit, will this be reported to the IRS?

 

Please let me know of your experiences on this topic.

 

 

 

 

[Jack from Ohio]

What state is your client in?

[SFA]

Pennsylvania

[cred65]

What is the basis for the reclassification?  Depending on the $$$ involved the client and you should be prepared to consult with an attorney that specializes in this area of practice.  The states and the feds do exchange data on these situations.  It could be costly.

[Max W]

Here is a little insight into PA's law.

It may be that the person in question is an employee, but the others are not.

There is always the possibility of bureaucratic overreach.

 

43 P.S. §753(l)(2)( b ).

In Hartman v. UCBR (opinion here), [this link doesn't work, use the one below.]

the Pennsylvania Commonwealth Court applied that legalese gobbledygook to a real-life situation. I love it when a court comes right out and states the holding:

We conclude that, as a matter of law, where an employer supplies all equipment, pays a fixed rate even when a job does not take place, requires that its business cards be distributed and other business cards be collected, and even goes so far as to determine how early a person must arrive at a job and what clothing a person is to wear, that employer is exercising significant control over the manner in which Claimant is performing his duties. Accordingly . . . Employer did not meet its burden of proving that Claimant was an independent contractor. 

http://www.lawfficespace.com/2012/02/pa-court-weighs-in-on-employee-vs.html

[Catherine]

Definitely talk to an employment law specialist for PA.  I have seen businesses go under after these reclassifications.  Also note that state rules vary; someone who is an "employee" by Massachusetts standards could well be an independent contractor by federal standards.  Nightmares.

[SFA]

Sometimes the answer really is that they truly are employees. So this situation is not about the argument of whether the determination is correct or not. I think we are past that.

 

The question here is what to do going forward and back to January of this year?

 

So far, we are having each employee complete a W-4 and related forms, then we are immediately setting them up to receive payroll checks. It is the pay from January through today, that have no withholdings and no prior payroll returns have been filed in 2014. Should they receive a 1099-Misc and a W-2 in 2014?

[kcjenkins]

No, you will need to W-2 them for the whole year.  You can show the actual withholdings, but will need to pay the full FICA  even though they did not deduct for the employee share.  Prior years you don't send W-s, just pay the bill.  And yes, IRS will tell the state, and they will bill the client too.  

[SFA]

No, you will need to W-2 them for the whole year.  You can show the actual withholdings, but will need to pay the full FICA  even though they did not deduct for the employee share.  Prior years you don't send W-s, just pay the bill.  And yes, IRS will tell the state, and they will bill the client too.  

 

Argh! Ok, so if the company pays the employees share of the social security and medicare tax (for January through July 2014 wages)--is that additional compensation to the employee? Should the compensation be "grossed-up"?

[jklcpa]

Argh! Ok, so if the company pays the employees share of the social security and medicare tax (for January through July 2014 wages)--is that additional compensation to the employee? Should the compensation be "grossed-up"?

 

 

Yes, it should be grossed up if the company is paying the employees' share of FICA and Medicare. The new gross would be the net check received divided by 0.9235. That is the gross amount that the FICA and Medicare will be based on, not the net amount that was actually paid to the employees.

[SFA]

Thanks everyone for your help. Not ruling out help from a qualified tax attorney, but for now, will gross up net pay in 2014, prepare 1st & 2nd quarterly payroll returns and issue only W-2's.

 

Catherine, you make a good point. Employer's can go under in these circumstances. When all their past products and services were priced and sold based on different pay structures, then to retroactively recalculate payroll, penalties, interest. Well that debt can drag a business to the bottom of the river. The penalties alone can kill a fragile company. It may happen in this instance too.

[JohnH]

_{I've never worked a situation where there was a wholesale reclassification of employees, so maybe this isn't feasible.  But what would be the harm in explaining the situation to the employees in detail,  and asking them to allow retroactive withholding of the EE portion of SocSec/Med back to the beginning of the year. Possibly proportionally spreading the under-withheld amounts through the remainder of this year.}   

 

_{I'm sure some employees would object, but others might be more fair-minded about it.} 

_{If the business is truly in jeopardy of folding, it might be wise to lay it all out to them and tactfully explaining that the plus side of agreeing is that they get to keep their job.}

[SFA]

Good idea John. We are planning to have a company-wide meeting to review all options. We are also planning to slightly adjust/reduce future compensation to factor in the benefits of employee status.

[michaelmars]

I went through this and there are things you should know.  Yes the states communicate but maybe not for a year or so.  Usually the state wants the unemployment insurance only but they will check and see if the individuals reported the income, if not then you are on the hook for swt too.

 

as for the feds. and this is important to look at, they have a voluntary disclosure and reclassification program where you basically fess up and promise to make these individuals employees for the current year and beyond.  NO penalties no back filing no nothing!  I think there was a fee of a few hundred dollars to apply but don't really recall.

 

The employer needs to explain how this doesn't cost the employees anything if they were paying the fica on their 1040 anyway.  We billed them for the current years fica catch up and spread it out to make it easier on them.  Didn't catch up on fwt or swt since they should have been making estimated payments anyway.

 

Here is a major problem, if the employees had pension plans, they can no longer contribute and any write-offs they took against the income is now subject to 2%.

 

For my doctors office, the state tried to reclassify even the landscaper and cleaning lady and even included payments to patients as refunds.  They basically list individual that a check was written to and make you prove who shouldn't be considered.

[MAMalody]

Last one I had like this was about 20 years ago. I don't usually deal with payrolls, however, I am wondering why, for the current year, the employer would be required to pay the employee portion of ss/mc?  Seems to me they could deduct that from the employee wages over the rest of the year? If the employee was making ES pymts. they would be taking that amount, or close to it, into consideration as being paid out anyway.

 

 

.

[JohnH]

Good point Mike. But I think the employer needs "buy-in" from the individuals being paid. In some states, it's probably illegal to make retroactive deductions from an employee's earnings without their approval. These people are now employees going back to the beginning of the year, so anything the employer does will probably fall under the laws dealing with employees rather than I/C's. It is going to be problematic, and could even stir up other legal issues.

So leveling with them and getting their cooperation would be wise. It may even be legally necessary. I'd even consider giving them longer than the remainder of the year to pay up the SocSec/Med "loan" if that's what it took to enlist their cooperation. And in spite of all that, there will probably be one or two who will try and take advantage of the situation no matter what the employer does. They really don't have any leverage with the employer, but sometimes people believe they do and will overplay their hand.

[kcjenkins]

Often the business has been paying more to them as a IC than they would have paid an employee, basically passing on the difference just to avoid the paperwork hassle of payroll.  So the workers may be shocked to discover the "pay cut" that comes now. But it only takes one 'fired' IC going for Unemployment to create a huge problem for the business, because the states all assume "employee" unless you can prove otherwise with a preponderance of the evidence.   Both feds and states prefer they be employees because then they get their taxes faster and surer, with fewer deductions allowed.  

[SaraEA]

Your client may be eligible for the Voluntary Classification Settlement Program.  He is not under IRS audit but state, so he could be eligible.  He only has to pay 10% of what he would have had to pay if the workers were properly classified, no interest or penalties.  The program has changed over time, so this link may be outdated, but if I remember from update courses it has not gotten more stringent.  http://www.irs.gov/irb/2012-51_IRB/ar16.html

[SFA]

Excellent suggestions. At first when I read about the IRS voluntary classification settlement program, I thought my client is ineligible because they have already been audited by our states department of labor. On second read, I see that there may be a path. I will suggest this course of action to my client. Thanks to you all.

 

If we go this route, what about the 2nd qtr 941 which is due on July 31st? I was going to recalculate gross wages and file the 941 on time to avoid late penalties. Perhaps there is guidance from the IRS on this. I will research more tomorrow.