I have a friend who is a freelance writer who does a lot of work for agencies. She got the following information from the one she works for. IT seems a little hinky to me. I asked if they had recently been taken over by a Nigerian Prince. Does any of this seem logical?
The contract agency from which I have received work this year has informed me that the federal government is cracking down on individual S corporations such as I had (I dissolved it after one year, in June
2010). So they are reclassifying me as a W2 as of January 1. This means I owe the contract agency social security and state and federal taxes for the money I earned from January until June and the contract agency will pay those taxes. The contract agency says that the corporation taxes my corporation paid the state of Illinois will be credited to me from the state at the end of the year because the contract agency will be paying its corporation taxes and if the state keeps the money that will be double taxation (I hope the state of Illinois sees it their way). They say that because of the federal government crackdown individual S corporations are going to be dropped by contract agencies. I am one of the first to feel this, they say, because I switched from a corporation to a W2 in the middle of the year, which will be a red flag to the IRS. They say their plan protects them and me from an audit.
That's impossible. Social Security and Federal Income Tax are owed to the IRS (US government). State income tax is owed to the state (whatever it calls its equivalent department).
If a contracting agency paid a corporation, it doesn't get to retroactively create an employee relationship.
They always are, as a credit against the taxes due.
That's a different corporation, with a different tax bill.
The state is willing to tax as many corporations as it can.
That's a prediction of a future event, not a retroactive requirement.
Many people drop private corporations when they get hired.
It especially protects them.
If I were in her position, I'd ask the company how much taxes they claim should be paid on my behalf, and inform them that I'd be making the payments directly to the taxing authorities, in order to ensure that there's no confusion as to their source or which account should get credit. And since I'd have been paying estimated tax all along, there wouldn't be anything additional to be paid anyway.
In reality, this looks like a company that's planning on going out of business in the near future and wants to take the money and run.
If someone is classified as an employee, state tax, as well as federal tax, is payed in advance as estimated tax payment. That's why the state is involved.
If the worker was actually an employee of the payor corporation, the IRS can reclassify the employment status, and charge the payor corporation for estimated tax payments as well as withholding tax.
So the corporation ought to do a lot of withholding starting immediately, if that's the case. I'm not aware of any legitimate cases where a company wanted the retroactively-classified employee to pay the company money (which, presumably, he already paid as his own estimated taxes) in order for the company to remit the taxes it should have been withholding.
First, let us not denigrate our good friends and colleagues at the IRS. It is CONGRESS who has legislation pending that will subject S Corp Pass Through Income to S/E tax. The IRS will be charged with enforcing it.
The proposed legislation, as it is now, calls for S/E tax being assessed on the pass through income for S Corp owners WHEN 3 or fewer owners are responsible for professional level income. Essentially, if your business is considered one of the Evil Eight professions, you'll be subject to the new rule WHEN it passes - it has NOT passed yet.
Here's what usually happens -
Someone sets up an S Corp -
Takes a small, token salary along with the associated payroll taxes, including OASDI and Medicare
removes BIG money in the form of distributions - subject to income tax BUT NOT OASDI or MEDICARE
An IRS TIGTA study some years ago showed that, on average, an S corp. showed $5K or wages to the officers/owners but paid over $300K in distributions which escaped S/E tax. Congress's new legislation is intended to "fix" this.
The collateral issue in your case is your classification with the company you do work for.
Many companies, in an attempt to avoid the costs and liabilities associated with employees, try to treat all their workers as contractors. Since the current law, which is also changing, requires that payments to UNINCORPORATED businesses be reported on Form 1099-Misc as nonemployee compensation, the paying company frequently "suggested" that the worker set up an S Corp. This allowed the paying company to treat the worker as a contractor and avoid any reporting of the amounts paid.
This structure kept the payor from paying anything towards the associated taxes - no match for OASDI or Medicare, no unemployment at the state or Federal levels - and it kept them from having to fund any benefit programs - no set asides for vacation or sick leave, nothing for health insurance or retirement programs. Instead it shifted all of the responsibility to the worker. NOTE I am not saying this is a bad thing SO LONG AS the worker really is a contractor.
The problem here is that in many cases the employing business required so much of the worker that they actually should have been treated as an employee. For example, if you run a donut shop and have an employee who has to show up for work every day at 5AM and do what you tell him to do, when you tell him to do it and he gets a pay check come Friday, no one would argue that he was an employee.
BUT if you run a construction company you may have an employee who you require to show up at 5AM, whom you tell what to do and how to do it, who drives your truck and uses your tools and who gets paid on Friday whether the company gets paid for the work done or not BUT who gets treated as a subcontractor - either by the issuance of a 1099 or by payment to the worker's S Corp.
When we consider "substance over form", the very rule of law that drives taxation, it is clear that the person doing the work is really an employee and is being misclassified. The government's position is that this misclassification robs the government of its rightful tribute (note the sarcasm?).
The real trouble usually comes with the worker gets let go - he files for unemployment and is denied because he wasn't reported as an employee. So he kicks and screams and the state investigates. If they find sufficient evidence that he should have been treated as an employee they kick it up to the IRS who also investigates.
If the IRS also determines that they were really an employee the employer can be held responsible for - get ready, its a biggie - THE TAXES THEY SHOULD HAVE WITHHELD PLUS PENALTIES - perhaps as much as 100% under the trust fund recovery rules - AND INTEREST. So if the payor messes up they could be on the hook for all the taxes they should have withheld AND THIS MATTER BECOMES A PRIVATE ISSUE BETWEEN THE COMPANY AND WORKER. Its up to the company to get back from the worker the taxes they paid on his behalf but failed to withhold - it is a private legal matter that the taxing authorities will not get involved with, they simply go after the company.
Yes, it sucks - too bad, suck it up.
This seems to be where the company paying you fears to tread. For whatever reason they've decided that they have been treating your incorrectly as a contractor and are changing the way you're paid.
What can you do about it -
Probably nothing - it harkens to what I call the McDonald's rule. If you're flipping burgers for McD's you are an employee.
BUT PERHAPS you really are a contractor - think of the relationship that a real company has with other real companies. If my tax business contracts with a painter to paint the office I can tell him the days and times the office is open and what color to use, but I cannot make him put a particular individual on the job. I don't supply him with the tools to do the job, though I may buy the paint directly or I may have to pay for any special tools he needs to do a job a particular way. I get to hold him to some standard of work and I may not pay him if I don't like the job.
So if you supply your own tools, set your own schedule, don't have to be the one to actually do the work, and may suffer an economic loss if the buyer doesn't like the end product then you may actually be a true contractor.
However, if the company you are working for will only pay you as an employee you have to consider two things:
First - do you want to keep working with them? If so, you may have no choice but to be paid as an employee;
Second - WHY are they making any such determination unless they have reason to believe that they have been doing something that could be wrong and get them in trouble. In which case you must understand that they have every right to require that anyone doing any work for them be an employee.
My question is, if the business is making money, why would someone set up an S-corporation rather than a C-corp? Seems to me that there are more benefits to a C-corp, at least when you're in the black.
They certainly do. But retroactively, and demanding money back?
Making up some numbers: contractor get paid $120K/year.
In the first 6 months, contractor (via S-Corp) received $60K. Contractor remitted $20K to the IRS for estimated taxes.
Now the company is telling contractor "You've been an employee all along and you have to repay us $20K that we should have withheld."
Where is contractor supposed to get that money from? The IRS isn't about to refund it.
Or, the employee could file a W-4 with enough exemptions not to be withheld (for "as of" January 1), and a realistic one as of July 1. That way, the company is safe, and the employee doesn't have to repay money that the IRS already has.
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