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Payroll Tax Issues - Treating Employees as Non-Employees

| November 23, 2020

If you treat an employee as a non-employee and you do not withhold social security, Medicare tax and income tax, you will usually be liable for these taxes. This can be devastating to a business. The IRS can come in and reclassify independent contractors as employees, and can add on penalties and interest along with the payroll taxes owed.

You may be able to figure your liability using special section 3509 rates for the employee share of social security and Medicare taxes and federal income tax withholding if you filed required Forms 1099. You can't recover the employee share of social security tax, Medicare tax, or income tax withholding from the employee if the tax is paid under section 3509. You are liable for the income tax withholding even if the employee paid income tax on the wages. You continue to owe the full employer share of social security and Medicare taxes. The employee is liable for the employee share of social security and Medicare taxes. For more information, read section 3509 (you can google it) for details. Also read the Instructions for Form 941-X (for quarterly filers) or the Instructions for Form 944-X (for annual filers).

You can't use Section 3509 rates if you willfully disregard the requirement to withhold taxes from the employee or if you withheld income taxes but not social security or Medicare taxes. Also, you can't use Section 3509 for reclassifying statutory employees. 


If the employer issued required information returns (Form 1099), the section 3509 rates are the following. 
• For social security taxes: employer rate of 6.2% plus 20% of the employee rate of 6.2%, for a total rate of 7.44% of wages.
• For Medicare taxes: employer rate of 1.45% plus 20% of the employee rate of 1.45%, for a total rate of 1.74% of wages.
• For Additional Medicare Tax: 0.18% (20% of the employee rate of 0.9%) of wages subject to Additional Medicare tax.
• For income tax withholding, the rate is 1.5% of wages.


If the employer didn't issue required information returns, the section 3509 rates are the following.
• For social security taxes: employer rate of 6.2% plus 40% of the employee rate of 6.2%, for a total rate of 8.68% of wages.
• For Medicare taxes: employer rate of 1.45% plus 40% of the employee rate of 1.45%, for a total rate of 2.03% of wages.
• For Additional Medicare Tax: 0.36% (40% of the employee rate of 0.9%) of wages subject to Additional Medicare Tax.
• For income tax withholding, the rate is 3.0% of wages.

If you have a reasonable basis for not treating a worker as an employee, you may be relieved from having to pay employment taxes for that worker. To get this relief, you must file all required federal tax returns, including information returns, on a basis consistent with your treatment of the worker. You can't have treated any worker with a substantially similar position as an employee. Read IRS Publication 1976, Do You Qualify for Relief Under Section 530.

If you aren't sure how to treat a worker, you can have the IRS determine whether the worker is an employee by filing Form SS-8.