If the IRS determines that an employee has been misclassified as an independent contractor, it may assess federal employment taxes plus interest and penalties. These matters frequently end up in the courts.
Latest example: Donald Cave’s law firm, an S corporation in Louisiana, specialized in personal injury actions. The fees generated by these lawsuits were the firm’s sole source of income in 2003 and 2004. All attorneys’ fees and reimbursements of case expenses were paid directly to the firm, which then paid a portion of the gross fee to the attorney handling the case.
Cave was the sole shareholder and president of the firm. In this capacity he:
- selected the associate attorneys who would work for the firm
- hired law clerks to provide legal services
- hired the support staff, including an investigator, receptionist and several secretaries
- set the hours for the support staff
- determined whether workers would receive bonuses and the amounts
- approved the payroll
- decided whether to make advance payments or reimburse workers for work-related expenses.
The firm treated Cave as an independent contractor, not an employee, but the IRS disagreed.
Tax outcome: The Tax Court sided with the IRS. An officer of a corporation who performs substantial services for a corporation and is compensated for those services is an employee for employment tax purposes. There was no evidence, such as a service agreement, to support a finding that Cave performed services for the firm in some other capacity. Also, theservices that Cave performed were fundamental to the operation. (Donald G. Cave A Professional Law Corp., TC Memo 2011-48)
Tip: It’s unlikely you can claim you’re an independent contractor if you own and run the business.