Employers cannot evade responsibility for deducting employment taxes from wages by simply declaring workers as contract labor. Only independent contractors qualify for exemption from tax withholding by employers.
The federal tax code defines the necessary conditions for independent contractor status. States also provide guidance on defining an independent contractor arrangement. Independent contractors basically present themselves as available for services to a variety of businesses at any time. They are assigned specific tasks to accomplish and work without direct supervision.
A business may produce an annual Form 1099, indicating the amount paid for contract labor. The form is sent to an independent contractor and the federal government. An employee receives Form W-2 annually, indicating gross compensation and taxes withheld.
Federal law requires employers to deduct certain taxes from employee compensation. These deductions include the employee’s federal income tax liability, determined from Internal Revenue Service (IRS) tables on the wages paid. The other deducted federal payroll taxes are the employee portions of Social Security and Medicare contributions under the Federal Insurance Contributions Act (FICA). No withholding of taxes is required from amounts paid to independent contractors. Instead, the independent contractors are entirely responsible for remitting taxes associated with their income.
Employers face penalties for failing to remit all withheld taxes, along with a matching amount of the FICA taxes, when they are due. Most important is the fact that payment of employment taxes to the U.S. Treasury is the responsibility of an employer. Therefore, liability for payment of taxes always rests with employers – even when taxes are not withheld. An employer who incorrectly classifies an employee as contract labor is responsible for payroll taxes. The IRS will assess back taxes on payments that are deemed disguised wages.
The IRS is permitted to collect unpaid payroll tax liabilities of corporations from individuals responsible for collecting and remitting the taxes. The customary protection of individuals from personal responsibility to pay corporate obligations does not apply to payroll taxes.
The IRS may seek to collect payroll tax deficiencies from several individuals for the same tax assessment. However, the IRS cannot collect more taxes than are owed by a business. In this policy of joint and several liability, the IRS conducts a tax assertion on multiple parties. If overpayment results, the last person to pay the taxes owed that caused the overpayment is entitled to a refund.
The IRS may assess a penalty for recovery of unpaid payroll taxes on any person who has status, duty and authority over financial decisions of the business and who willfully failed to collect, truthfully account for and pay payroll taxes.
Essentially, the control person of a business is not permitted to knowingly pay other creditors with payroll tax money payable to the IRS. A responsible person has been defined by court cases and administrative rulings as someone who possesses authority to decide which creditors to pay and when to pay them. Consequently, the test for personal liability is an assessment of who controls payment decisions, regardless of the person’s business title.