What are the consequences of IRS "reclassification" on both employer and employee?

Question

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.

Answer 1

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.