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Withholding tax: whose liability is it?

Withholding Tax Whose Liability Is It?

Although much has been written regarding the definition of employee vs. independent contractor status, many employers remain unclear as to how to make this determination. As a result, taxpayers may be given a Form 1099-MISC by an employer indicating the receipt of "non-employee compensation" during the year when it is obvious to the preparer or interviewer that the worker is an employee and not self-employed.

If the accountant is not absolutely sure of the worker's status, it may be prudent to prepare a Form SS-8, Information for Use in Determining Whether a Worker Is an Employee for Federal Employment Taxes and Income Tax Withholding. The original form should be filed with the local IRS district director and a copy attached to the taxpayer's return.

Because the earnings of an employee are generally excluded from the definition of self-employment income under Internal Revenue Code Section 1402(c), those earnings should obviously not be subject to self-employment tax. However, it must first be determined for sure whether or not the worker is actually an employee and whether or not the employee wants to pay the self-employment tax. If the taxpayer is obviously an employee and doesn't want to pay the tax, one may simply attach a Form 4852, Employee's Substitute Wage and Tax Statement, to the return in place of the missing W-2 Form and not compute the self-employment tax.

Be absolutely certain of the client's employee status, otherwise penalties for understatement of tax may result. In addition, the client should be advised to contact a Social Security office within three years of the time the wages were earned to make sure credit for the earnings is recorded on his or her permanent Social Security record. The Form SS-8 takes a little time to prepare, however it may save your client from the payment of self-employment tax, making your fee a worthwhile investment.

If self-employment tax is not computed, the practitioner must be sure to: 1. Obtain taxpayer permission to

allow the Service to disclose his

or her name to the employer

(necessary for an IRS determination

of employee status using

Form SS-8). Employees are often

upset when they learn that

they owe a considerable amount

of taxes because their company

has tried to save on the payment

of payroll taxes and may be quite

willing to grant that permission. 2. Ensure that the IRS service center

is not making automatic adjustments,

adding the self-employment

tax to the tax liability

when income for which an employer

has issued a Form 1099-MISC

is reported, without an

audit or hearing. These adjustments

were protested recently

under the due process provisions

of the U.S. Constitution.

Should the Employee Pay


There is no place on a Form 1040 tax return for an employee to pay FICA taxes not withheld by the employer, although there is a provision on Form 4137 for employees receiving tips. If an employer does not withhold part of the FICA taxes form the taxpayer's pay, the taxpayer may find that he or she owes money to the government at tax time. For many, this is money that has usually already been spent.

If the money had been withheld according to law, the employee would possibly be looking forward to a refund. This is the reason the withholding provisions were enacted in the first place.

If the employee pays FICA taxes in the form of self-employment taxes and the IRS catches up with the employer before the statute of limitation closes, the tax will have been paid twice, unless the employee is able to get a refund and/or the employer gets a substantial reduction of the liability under Code Section 3509. Even then there is some duplication of the payment of the tax.

The employer is liable to the government for the payment of income tax that has not been withheld, and the taxpayer employee apparently cannot get credit for this withholding tax on the Form 1040 unless it has actually been withheld by the employer. However, Section 3402(d) provides that the employer is not liable for the payment of income tax withholding if it can be shown that the employee reported and paid any income tax due on the wages which generated the income tax withholding liability. Even when it can be proven that the employee has erroneously paid self-employment FICA tax, the employer is still liable for paying FICA tax in that employee's behalf unless the statute of limitations has expired.

Nevertheless, if the employer has a high turnover in employees, poor relations with employees or former employees or the employees do not keep records that prove the tax was paid, the employer may not be able to benefit from Code Section 3402(d). Further, Section 3402(d) applies only to income tax withholding and not to Social Security taxes.

If a Form SS-8 is filed in time for the IRS to audit the payroll records, the employer will generally have to pay the employer's and the employees' share of the FICA taxes even though he did not withhold. However, Section 3509 provides for payment by errant employers at a reduced rate, and if the employer must pay the FICA tax anyway, why should the employee volunteer to pay it in the form of self-employment taxes?

The Employers' Liability

In 1982, Code Section 3509 was enacted to reduce the liability for employers who have treated employees as being self-employed and who must subsequently reclassify them as employees. The rationale for lowering the taxes for employers, as stated in the committee reports, was that, because of the difficulty in substantiating whether an employee paid the income tax due, the employer may have to pay it as well. In the case of FICA taxes, even where information on employer tax payments is available, there is a possibility of double collection of Social Security taxes, and employees seldom file for a refund of erroneously paid Social Security self-employment tax. Nothing in Section 3509 appears to indicate that Congress intended to deny the employees the right to the refund. However, the Service now routinely disallows these claims.

Did Congress intend to make employees liable for self-employment tax when Section 3509 was enacted? Indeed, the statute itself says that the employee's liability shall not be affected by the assessment of tax under Section 3509. Moreover, if a person is in fact an employee, the employer should not be able to change that employee's tax liability just to lower his or her own. If the employee could get a refund of erroneously paid self employment taxes before the enactment of 3509, then he or she should be entitled to such a refund afterwards.

Section 3509 Tax Break for


Under Code Section 3509, employers who have failed to withhold income taxes from their employees may pay 1% of wages for income tax withholding if a Form 1099 was issued and double that (3% of wages) if a 1099 was not given the employee. The employers' Social Security tax liability is 20% of the amount imposed under Chapter 21, (of which the employer ordinarily would have had to pay 100% had he not withheld the employees' share) and double that (40% of the regular liability) if a 1099 was not issued to the worker.

The Employee's Liability

There is nothing in Code Section 3509 that might indicate a congressional intent to raise the employee's liability when granting a tax break for errant employers. In fact, in the entire Internal Revenue Code, only Section 6521 would switch the liability for the payment of the FICA tax from the employer to the employee. Section 3509(d)(C) (relating to the employer's reduction of tax) says that Section 6521 shall not apply when the employer's tax is computed under Section 3509. However, in writing the proposed regulations, IRS changed the "shall" to "may" without any statutory authority.

"Sections 3402(d) and 6521 shall not apply with respect to such employer's liability determined under this section, although section 6521 may apply with respect to an employer's liability determined under whether the employer's liability is determined under Section 3509." Section 6521 simply states that, in the case of self-employment tax imposed under Chapter 2 or FICA tax imposed under Chapter 21, if the employment is treated erroneously, one tax may offset the other when part of the tax cannot be collected from another party because of "a law or rule of law," generally the statute of limitations.

As an example, in Texas in the early 1970s a large group of fishing boat owners were filing refund claims for employment taxes paid and advising their employees to pay self-employment taxes. Eventually an appeals court reversed the employers' position, so the employees started filing refund claims for the self-employment taxes paid.

All of the refund claims were paid with the exception of one. A suit was then filed in federal district court for the amount of the self-employment tax paid by the employee. However, because of the delay in getting a court hearing, the statute of limitations closed so that IRS could not collect the Social Security tax under Section 3102(b) from the employer. As a result the employee taxpayer was refunded only about half of the self-employment tax.

Code Section 3509 states that "the employee's liability for tax shall not be affected by the assessment or collection of the tax so determined." Further, in the event there is any doubt that the employee should not be taxed, the Code specifically says, "Section 6521 shall not apply."

That should settle the dispute. The employee had no liability for Social Security taxes because Section 3102(b) puts that liability on the employer, and the liability with respect to the employee "shall not be affected" by Section 3509.

Regulations written under Code Section 3102 indicate that the employer is liable for payment of Social Security tax whether it is withheld or not. Then they hedge a bit by stating that sometimes the employee is also liable, obviously taking into consideration Internal Revenue Code Section 6521. But there is no authority in Section 3102 for the IRS to shift the liability for the payment of the Social Security tax that has not been withheld directly from the employer to an employee other than a tipped employee.

The regulations written under 3102 were written long before Section 3509 was enacted in 1982; therefore, it is ludicrous for IRS to cite the Section 3102 regulations when interpreting Code Section 3509.


Employees are not liable for self-employment taxes whether the employer has treated them as being self-employed or not. The facts control. Either the worker is an employee or not under common or statutory law.

The worker has no control over how the employer may choose to report wages. There is no other situation whereby one taxpayer's tax liability can be changed by another person, other than by a return preparer making some sort of an election for the taxpayer. And even then, the taxpayer must sign the return in order to change the liability.

If a client is an employee under the facts, he should file his tax return the same as all other employees, reporting his income tax liability with no self-employment tax added.

William L. Fulcher is a partner in the firm of Fulcher & Buitureida and has been a practicing accountant in Brownsville, Texas, since 1968. He is enrolled to practice before the IRS, having passed the 1971 Special Enrollment Exam in the top 20 nationwide. He has been a member of NSPA since 1971 and is a life member of TAPA, NSPA's Texas affiliate. He received his bacherlors degree in accounting (magna cum laude) at Pan American University in 1979 and his MBA in 1983. He has published numerous articles in a number of professional publications including the National Public Accountant.
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Title Annotation:proper filing liability by employer and employee
Author:Fulcher, William L.
Publication:The National Public Accountant
Date:Sep 1, 1991
Previous Article:Tax planning for start-up costs.
Next Article:NSPA Scholarships awarded to outstanding students.

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