A Primer on Employment and Self-Employment Taxes
Employment and self-employment taxes have been around a long time. In 1935, Congress passed the Federal Insurance Contribution Act (FICA), which imposes taxes on employees and employers for compensation paid to employees. The taxes from FICA are used to provide funds for Social Security and Medicare. In 1939, Congress passed the Federal Unemployment Tax Act (FUTA), which imposes taxes on employers for compensation paid to employees. FUTA taxes provide funding for unemployment compensation to workers who lose their jobs. Later, in 1954, Congress enacted the Self-Employment Contributions Act (SECA). SECA taxes provide funds for self-employed individuals to claim benefits under Social Security or Medicare.
This Insight provides an overview of FICA, FUTA, and SECA. It also provides background on reporting and withholding obligations in addition to IRS enforcement and potential defenses.
- FICA and FUTA Taxes.
1. The Definition of “Employee.”
Generally, only employees are subject to FICA and FUTA taxes. For these purposes, the Code defines “employee” broadly to include, among other things, any individual who would meet the definition of an employee under common law principles. I.R.C. § 3121(d). Under this common law test, federal courts and the IRS look to a variety of factors in the service provider and service-recipient relationship.
More often than not, a driving factor is the degree of control the service-recipient has over the service-provider. Specifically, federal courts and the IRS both look at whether the service-recipient controls not only the work and details to be accomplished but also the means in which it is accomplished. Treas. Reg. § 31.3121(d)-1(c)(2) (“[A]n employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done.”); see also Santos v. Comm’r, T.C. Memo. 2020-88. Conversely, if the service-provider is subject to the control or direction of the service-recipient only with respect to the result that is to be accomplished, the service-provider is generally treated as an independent contractor and not subject to FICA and FUTA taxes. See Treas. Reg. § 31.3121(d)-1(c)(2).
Specific factors that courts and the IRS analyze in making a determination of employer/independent contractor status include:
- The degree of control over the performance of the individual’s services;
- The particular type of services rendered and whether those services require skill and training;
- The party who provides the facilities and equipment or tools to perform the services;
- The length of the service provider’s relationship with the service recipient;
- How services are compensated (g., fixed sum or hourly);
- Whether the service provider has any entrepreneurial risk for profit and loss;
- Whether the service recipient has the ability or right to terminate the services at any time.
The term “employee” also includes corporate officers and other statutory employees. I.R.C. § 3121(d). Generally, a corporate officer is an employee if the officer provides significant services to the corporation. However, corporate officers who perform minimal services are generally not considered employees for these purposes. Davis v. U.S., 74 AFTR 2d 94-5618 (D. Colo. 1994).
Statutory employees include those specifically listed in the Code. See I.R.C. § 3121(d)(3). These include, among others, individuals who perform services for compensation for any person as an agent- or commission-driver engaged in certain distribution channels, life insurance salesmen, home workers, and traveling or city salesmen. Id.
There are statutory exceptions to FICA and/or FUTA, regardless of the relationship between the service-provider and service-recipient. For example, FICA and/or FUTA is not required with respect college student employees, religious service providers, fishing crews, and real estate agents. See, e.g., I.R.C. § 3121(b), 3508.
- FICA Taxes.
FICA requires employers to withhold 6.2% from employee pay for “Old-Age, Survivors, and Disability Insurance” (OASDI)and 1.45% for “Hospital Insurance” (HI). I.R.C. §§ 3101, 3102. In addition to this withholding requirement, employers must also remit a matching amount to the government (i.e., 7.65%). I.R.C. § 3111. Thus, cumulatively, FICA requires the employer to remit a total of 15.3% to the government, subject to certain base limitations discussed below. In addition, since 2013, the Code has imposed a 0.9% employment tax on employees for compensation that exceeds certain thresholds, depending on filing status. See I.R.C. § 3101(b)(2).
The base limitation – or the amount of compensation subject to OASDI tax – varies each year due to inflation adjustments. See 42 U.S.C. § 430. For tax year 2020, the base limitation is $137,700. See SSA Notice, 82 Fed. Reg. 59,937 (12/15/17). In 2018 and 2019, the base limitation was $128,400 and $132,900, respectively. See SSA Notice, 83 Fed. Reg. 53,702 (10/24/18); SSA Notice, 84 Fed. Reg. 56,515 (10/22/19). However, all wages received by an employee are subject to the HI portion of FICA taxes.
FICA tax obligations are reported to the IRS quarterly on Forms 941, Employer’s QUARTERLY Federal Tax Return. Generally, the filing deadlines for the 1Q, 2Q, 3Q, and 4Q Forms 941 are April 30, July 31, October 31, and January 31, respectively.
- FUTA Taxes.
FUTA is often run in conjunction with State unemployment programs. It imposes a maximum 6% employment tax on wages paid in a calendar quarter on the first $7,000 of wages paid to the employee. I.R.C. § 3301. For FUTA taxes, the employer is solely liable for the tax. Treas. Reg. § 31.3301-1. However, in most cases, the 6% FUTA tax is reduced to take into account credits employers receive for the payment of State unemployment taxes. I.R.C. § 3302. In essence, the maximum total credits an employer can receive for payment of State unemployment taxes is 90% of the 6% tax rate. I.R.C. § 3302(c)(1), (d)(1). In other words, the maximum FUTA tax, after application of maximum credits, is 0.6%.
FUTA tax obligations are reported to the IRS annually on Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return. Generally, the due date for the Form 940 is January 31 of the calendar year in which the Form 940 taxes arose.
- Income Tax Withholding.
To help finance World War II, Congress enacted legislation requiring employers to withhold and remit a portion of its employees’ paychecks to be credited against the employees’ income taxes. This withholding system continues today in accordance with various tables prescribed by the IRS. See I.R.C. § 3402. Thus, every employer must deduct and withhold income tax on an employee’s wages. If the employer fails to do so, the employer can become liable for the income tax withholding amounts. I.R.C. § 3403.
B. Self-Employment Contributions Act.
SECA imposes a 15.3% self-employment tax on the earnings of a self-employed person or independent contractor. I.R.C. § 1401. The SECA tax is subject to the same base limitations as discussed above regarding FICA taxes. Generally, self-employment income is defined as net earnings from self-employment (i.e., a trade or business), less wages subject to withholding. I.R.C. § 1402(b). However, if self-employment income is less than $400, no SECA tax is imposed. I.R.C. § 1402(b)(2).
There is no independent employment tax form analogous to Forms 941/940 a self-employed person or independent contractor must file with respect to SECA taxes. Rather, SECA taxes are computed and reported on the individual tax return (Form 1040) through the attachment of a Schedule SE, Self-Employment Tax, form. In addition, because a self-employed person or independent contractor pays the entire 15.3% SECA tax (compared to the employee’s payment of only half this amount, or 7.65%), the Code generally permits the self-employed individual or independent contractor to deduct one-half of the SECA tax, usually above-the-line in determining adjusted gross income. See I.R.C. § 1402(a).
C. Failure to Pay FICA, FUTA, or SECA Taxes.
If an employer fails to withhold the employee’s portion of FICA taxes from the employer’s payroll, the employer becomes directly liable for the tax. I.R.C. § 3102(a). This, of course, is in addition to the employer’s portion of FICA and FUTA taxes not paid to the government. However, the government may also assert trust fund recovery penalties ( with respect to the employee’s portion of FICA and income tax withholding) against “responsible persons” who manage or control payroll decisions for the employer (if it is an entity). See I.R.C. § 6672.
Conversely, the failure to pay SECA taxes to the government generally arises in a different context than the context regarding FICA and FUTA taxes. This is primarily because of the different reporting requirements and the different manner in which the taxes are computed.
Specifically, underpayments of SECA tax generally arise from the IRS: (1) attempting to recharacterize non-trade or business income as self-employment income; (2) increasing the amount of self-employment income reported on the taxpayer’s Form 1040 (e.g., Schedule C); or (3) disallowing expenses claimed as trade or business expenses. If successful, the IRS makes the assessment of SECA tax through an assessment of the individual’s income tax return. Treas. Reg. § 1.1401-1(a).
D. Defenses to Employment and SECA Tax Classifications and IRS Audits.
- Employment Tax and Income Tax Withholding.
There are various defenses a taxpayer may raise if the IRS asserts employment taxes were not properly withheld. First, the service-recipient may, in the right circumstances, argue that the service-provider was an independent contractor and thus not an employee. As one recent Tax Court opinion shows, this argument alone can carry the day. See Santos v. Comm’r, T.C. Memo. 2020-88.
In addition, service-recipients can also take advantage of an off-Code provision known in tax parlance as Section 530 relief. To qualify for this relief, the service-recipient must show: (1) all information returns (i.e., Forms 1099) have been timely filed for the service-provider; (2) the service-recipient otherwise treated the worker (and similar workers) consistently as independent contractors; and (3) the service-recipient had a reasonable basis for not treating the service-provider as an employee. Generally, the taxpayer can show reasonable basis by showing that: (1) the taxpayer reasonably relied on federal tax authorities for its position; or (2) the IRS had previously audited the business but did not reclassify similar workers as employees (however, this prong is not met if the IRS audit occurred in 1997 or later); or (3) the taxpayer treated the workers as independent contractors because the service-provider knew, and can substantiate, that was how a significant segment of its industry treated similar workers; or (4) the taxpayer relied on some other reasonable basis, such as the advice of an attorney or CPA who knew the facts about the business. Taxpayers eligible for Section 530 relief are not required to pay any asserted employment taxes for those workers.
A second option, aside from Section 530 relief, is I.R.C. § 3509, which permits employers to pay a reduced amount of employment taxes if certain requirements are met. Generally, under I.R.C. § 3509, the employer’s withholding tax liability for income taxes may be reduced to 1.5% of the wages paid to the reclassified employee, and the employer’s liability for the employee’s share of FICA taxes may be reduced to 20% of the amount of the reclassified employee’s compensation. However, I.R.C. § 3509 relief does not reduce the employer’s liability for its share of FICA taxes. See Prop. Reg. § 31.3509-1(a)(2).
To meet the requirements for I.R.C. § 3509 relief, the employer must have treated the employee as an independent contractor. Accordingly, this relief is not available if the employer withheld taxes from the employee’s paycheck. See, e.g., Consolidated Flooring Servs., Inc. v. U.S., 42 Fed. Cl. 878 (1999) (“In the present case, section 3509 does not apply to reduce plaintiff’s tax liability because by withholding taxes from the helpers’ wages during the years in question . . ., plaintiff treated the helpers as employees.”). Under proposed regulations, an employer has treated an employee as an independent contractor if, because of his belief that the employee was no an employee, the employer: (1) has failed to deduct and withhold income and employment tax for the calendar year, and (2) has failed to file one or more employment tax returns (including Forms 941, 940, and W-2) for any period during the calendar year with respect to such employee. Prop. Reg. § 31.3509-1(b)(2). In addition, I.R.C. § 3509 relief may not be granted if the employment and income tax withholding liability arose due to the employer’s intentional disregard of the requirements to deduct and withhold. I.R.C. § 3509(c).
Notably, the favorable rates of I.R.C. § 3509 may be increased in certain instances. For example, the income tax withholding rate may be increased from 1.5% to 3%, with FICA taxes raised from 20% to 40%, if the employer failed to meet certain information return requirements (i.e., issuing Forms 1099), unless the employer can show the failure was due to reasonable cause. I.R.C. § 3509(b).
The IRS also offers certain administrative relief to reclassify workers as employees, which is referred to as the Voluntary Classification Settlement Program (VCSP). To participate under the VCSP, the taxpayer must meet the following requirements: (1) the taxpayer must be currently treating its workers as independent contractors; (2) the taxpayer must have consistently treated the workers as independent contractors, including having filed all Forms 1099 for the workers to be reclassified under the VCSP for the previous 3 years; (3) the taxpayer cannot currently be under an employment tax audit by the IRS or any worker classification audit by the Department of Labor or a State government agency; and (4) if the IRS or the Department of Labor has previously audited a taxpayer concerning the classification of workers, the taxpayer must have complied with the results of that audit and not be currently contesting the classification in court. If the taxpayer meets the requirements of the VCSP and elects into that program, the taxpayer must pay 10% of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year. However, the taxpayer is eligible to use the reduced rates of I.R.C. § 3509(a) discussed above. In addition, the taxpayer is not liable for any interest and penalties on the amount.
- SECA Tax.
As discussed above, self-employed individuals are not subject to FICA and FUTA taxes. However, they are subject to SECA tax, which is computed and reported on their individual income tax returns (Form 1040) each year.
In many cases, a successful defense to the IRS’ assertion of SECA tax requires the taxpayer to show that the income at issue is not self-employment income (i.e., it is not trade or business income). To determine whether income is subject to SECA, federal courts and the IRS look to the facts and circumstances to determine whether the taxpayer was engaged in a trade or business. More specifically, federal courts and the IRS consider whether the taxpayer: (1) was “involved in the activity with continuity and regularity,” (2) devoted “sufficient time over a substantial enough period” to the activity; or (3) advertises to others that he or she is engaged in the selling of goods or services. See Comm’r v. Groetzinger, 480 U.S. 23, 35 (1987); Synder v. U.S., 674 F.2d 1359, 1364 (10th Cir. 1982); Green v. Comm’r, 83 T.C. 667, 686 (1984).
- Penalty Defenses.
There are a litany of penalties the IRS can assert for failure to properly withhold and remit employment taxes and file the necessary employment tax forms. First, the IRS can impose failure-to-deposit penalties under I.R.C. § 6656. Under I.R.C. § 6656, the penalty amount is equal to the “applicable percentage” of the underpayment, and the “applicable percentage” is: (1) 2% if the failure continues for not more than 5 days; (2) 5% if the failure continues for 6-15 days; and (3) 10% if the failure is for more than 15 days. I.R.C. § 6656(b)(1)(A). In addition, if the required deposit is not made within 10 days after the IRS issues a notice and demand for payment, the “applicable percentage” increases to 15%. I.R.C. § 6656(b)(1)(B). However, much like with other penalties under the Code, the failure-to-deposit penalty does not apply if the failure was due to reasonable cause and not willful neglect. I.R.C. § 6656(a).
Generally, the individual facts and circumstances for the failure-to-deposit will drive whether the taxpayer can show reasonable cause. However, the IRS and the federal courts look to the following factors in making this determination:
- Whether the person responsible for making the deposit (or someone in his or her family) had a death or serious illness;
- Whether the person responsible for making the deposit had an unavoidable absence from work;
- Whether the employer suffered from the destruction of business records or place of business, for example, by fire or other casualty;
- Whether the taxpayer’s ability to make deposits was materially impaired by a civil disturbance;
- Whether the taxpayer was unable to comply with the deposit requirement for reasons beyond his or her control.
In addition to the failure-to-deposit penalty, the IRS can also assert penalties for late payment of employment taxes in addition to late filing for not timely filing employment tax returns. See, e.g., Diamond Plating Co. v. U.S., 390 F.3d 1035 (7th Cir. 2004) (also noting that financial hardship may constitute reasonable cause for abatement of penalties for nonpayment of taxes “in some circumstances”). However, taxpayers can successfully rebut these penalties through a proper showing of reasonable cause. See I.R.C. § 6651(a).
E. Final Thoughts.
Employment and SECA tax audits can be frustrating to taxpayers. Many times, reclassification or additional assessments of employment tax can result in a significant drain to employer resources, particularly where the IRS (commonly) asserts penalties. However, taxpayers should be aware that there are options to successfully navigate an IRS employment or SECA tax audit.