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To begin, let me clarify that this question is not about how to avoid IRS reclassification. I want a better understanding of the consequences when it happens.

Here, I am referring to when the IRS decides that a contractor, who typically has wrapped an S-corporation around himself, is not legally a contractor for tax purposes, but rather an employee of each of the individuals for whom he provided services.

My understanding is that a contractor incorporates himself as an S-corporation in order to be able to deduct health insurance and business expenses from his taxable income as well as to avoid payroll taxes on part of his income.

Let's suppose for the sake of discussion that we are talking about Bob, a software developer who operated as a contractor for the year 2013. During 2013, he provides services for Adventureworks and Alpine Ski. He bills each client $50,000 for his services.

During 2013, he spends $10,000 on a new computer and specialized software. He also spends $10,000 on health insurance. As an S-corporation, Bob pays himself a salary of $60,000 a profit distribution of $11,000, and $9,000 in payroll taxes. (15%) In this example, I will not consider any other expenses.

Once again, the gross revenue is $100,000, business expenses are $20,000, salary is $60,000, payroll taxes are $9,000, and profit is $11,000.

Let's suppose that the IRS rules that Bob is not a contractor, but rather an employee of both Adventureworks and Alpine Ski.

I am looking for a better understanding of what happens to Bob and his employers, but let me lay out my limited understanding. It's a tax and legal disaster for everyone!

Bob and his employers are now responsible for paying 15% payroll taxes on all of the fees paid to his S-corporation (because it is now considered salary paid by Adventureworks and Alpine Ski). A big chunk of this is paid by Adventureworks and Alpine Ski because they are now responsible for the employers' 1/2 of the payroll taxes (since they are considered to have employed Bob as an employee). In addition, all parties involved will be ordered to pay penalties on top of these taxes. (How much?) Effectively, Bob has paid for his health insurance and the tools for his work with after-tax dollars, costing him thousands of dollars.

Furthermore, Adventureworks and Alpine Ski may be penalized for not providing Bob with the same benefits that they provide to their other employees as a matter of course. How are they likely to be penalized? I wouldn't think that the IRS could force them to retroactively add Bob to their group health insurance (and that would be a cluster anyways, since Bob bought his own insurance). I suppose they could force them to pay Bob for unused vacation time.

It all seems very muddy to me.

Please help me understand the consequences of IRS reclassification thru the lense of the fictitious example I've provided.

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Vivian River
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    My understanding is that the reclassification is more of an issue for the employer than the employee. Now they have to pay Bob on a W2 instead of 1099, along with all the payroll taxes. Bob could likely refile his tax return and get a refund. I'll let someone else answer, though, unless I can find some references... – Rocky Dec 04 '14 at 19:55
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    Is this a hypothetical situation, or a real one? If it is hypothetical, then there isn't enough information here on why the IRS decided to reclassify the situation. If it is real, then the person needs some legal advice addressing all of the details. – Ben Miller Dec 06 '14 at 15:02
  • This is strictly a hypothetical situation, but it is rather similar to real situations I've heard people talk about in both meatspace and cyberspace. Bob is not a real person, but he is like people I know. It is quite obvious that it would be extremely unwise to make legal or tax decisions based on answers given on a web site such as this. – Vivian River Dec 07 '14 at 15:42
  • This question appears to be off-topic because it is about a hypothetical situation and not a real issue the OP might be facing. – littleadv Dec 08 '14 at 05:00
  • @RiceFlourCookies I commend your understanding that mere reading random articles suggesting to evade taxes is not enough to become an educated person. I'm pretty sure the people you know who're in Bob's situation are going to get hit hard, sooner or later. This is one of the more enforced areas, and single-owner S-corps are very frequently targeted for audits. If these people hadn't been penalized yet - they will be. – littleadv Dec 08 '14 at 05:02
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    I find this question very confusing. I can see the IRS auditing the S-Corp and reclassifying the distributions as wages, but I have never heard of an employee of an S-Corp being reclassified as an employee of one of the S-Corp's customers, let alone 2 customers. Has this ever happened before? My understanding is the contractor reclassification happens for 1099 vs employee, not paid invoices to a corporation. – TTT Oct 26 '17 at 16:31

1 Answers1

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You are confusing entirely unrelated things.

First the "profit distribution" issue with Bob's S-Corp which is in fact tax evasion and will probably trigger a very nasty audit. Generally, if you're the sole employee of your own S-Corp, and the whole S-Corp income is from your own personal services, as defined by the IRS - there's no profit there. All the net income from such a S-Corp is subject to SE tax, either through payroll or through your K-1. Claiming anything else would be lying and IRS is notorious for going after people doing that.

Second - the reclassification issue. The reason employers classify employees as contractors is to avoid payroll taxes (which the IRS gets through Bob's S-Corp, so it doesn't care) and providing benefits (that is Bob's problem, not the IRS). So in the scenario above, the IRS wouldn't care whose employee Bob is since Bob's S-Corp would have to pay all the same payroll taxes.

The reclassification is an issue when employees are abused. See examples of Fedex drivers, where they're classified as contractors and are not getting any benefits, spend their own money on the truck and maintenance, etc. The employees are the ones who sued for reclassification, but in this case the IRS would be interested as well since a huge chunk of payroll taxes was not paid (driver's net is after car maintenance and payments, not before as it would be if he was salaried).

So in your scenario reclassification is not as much a concern to Bob as his tax evasion scheme claiming earnings from performing personal services as "profits from S-Corp". A precedent to look at, as I mentioned elsewhere, would be the Watson v Commissioner case.

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  • -1: This does not answer the question at all. You are talking about why reclassification might happen while alleging that Bob committed tax evasion. This says nothing about what consequences result from reclassification. – Vivian River Dec 05 '14 at 16:16
  • @RiceFlourCookies I'm not sure I follow. You pretty much covered that in your question. – littleadv Dec 05 '14 at 17:04
  • There is not enough information in the question to determine whether or not "Bob" has committed tax evasion. – Ben Miller Dec 06 '14 at 16:28
  • @BenMiller no, it's pretty clear. – littleadv Dec 06 '14 at 22:45
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    I've had some more time to review this answer. Apparently, the key term here is personal services. This is discussed in more detail here: http://www.techrepublic.com/article/get-on-your-own-payroll-to-save-on-self-employment-taxes/ – Vivian River Dec 07 '14 at 15:58
  • @RiceFlourCookies That's a good article, directly contradicting the first part of this answer. – Ben Miller Dec 08 '14 at 02:49
  • @BenMiller too bad it also contradicts the law. Pay attention: the writer is not a CPA or a attorney. When you get in trouble - he's not the one who's going to pay the penalties. – littleadv Dec 08 '14 at 04:45
  • @littleadv Which law? – Ben Miller Dec 08 '14 at 11:40
  • @littleadv, thanks for helping. You are the first person to suggest to me that there is anything illegal about what Bob's operation. Given how tricky some of these tax issues are, the only thing that has become clear is that Bob (and his acquaintances who engage in similar operations) need to seek advice from a qualified professional. From what I've gathered, the crux of the matter is whether or not Bob's S-corp is considered a "personal services company". After all, when Bank of America is too big to fail, Bob is far too small to be allowed to succeed. – Vivian River Dec 08 '14 at 16:55
  • @RiceFlourCookies I'm not sure "personal services company" has anything to do with it. Personal services company is taxed differently, but I'm talking about one-owner S-Corp which derives revenue from personal services. Not the same issue. Anyway, professional advice is a must, and if a licensed tax adviser (EA/CPA/Attorney) signs this off - he bears at leas some of the risks. – littleadv Dec 08 '14 at 16:59
  • @BenMiller you can ask a separate question, if you're so interested, but it is a huge topic to cover in an answer, let alone a comment. – littleadv Dec 08 '14 at 17:00
  • @littleadv I was going to ask the question, but then I remembered that it had already been asked. You and I each offered opposing answers, and I didn't see a law or source cited in your answer on that question, either. – Ben Miller Dec 09 '14 at 19:24
  • @BenMiller you didn't quote any laws either. There's a reason for that: the definitions in the laws are very vague. This allows IRS to enforce contradicting things: reasonable salary for C-Corp (that you talk about in your example of hiring someone) is not the same as reasonable salary in S-Corp, per the IRS. There have been numerous court cases on the issue, and you're more than welcome to google them. When the owner draws more than the SS limits - the IRS probably won't go after him, giving him savings of medicare. But below SS limits - you're playing with fire. – littleadv Dec 09 '14 at 23:27
  • @littleadv You might be right, but taking a little advice I'm not going to trust the word of a random person on SE without some sources. I've read the IRS pub and two articles linked both here and on the other question which all seem to contradict you. I am legitimately interested in what you have to say, and would love to see you support your position with some sources, either here or on the other question. – Ben Miller Dec 10 '14 at 00:45
  • @BenMiller Watson v Commissioner is a good example. The IRS forced to re-characterize the earnings up to the SS limit as salary, even though it was distribution from a partnership he was part of (that had employees) and not necessarily earnings due to his own performance. In the case of Bob above - it further affirms my point, since all the earnings of Bob's S-Corp are directly linked to Bob's services. – littleadv Dec 10 '14 at 01:50
  • @littleadv According to this Forbes article on Watson v. Commissioner, the IRS set Watson's salary not based on the SS limits but on a market compensation study. – Ben Miller Dec 10 '14 at 04:31
  • @BenMiller of course, they can't just say "we want him to pay maximum SS taxes". How hard do you think it is to substantiate max SS limit as reasonable salary for a CPA (as Watson) or a software engineer (as Bob in our example)? Not very hard. Bob is taking half the limit as salary and the rest as "distribution" - hence the evasion. – littleadv Dec 10 '14 at 04:39