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U.S. Master™ Payroll Guide, 2008 Edition
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CCH® PAYROLL — 7/23/08

IRS allows reduced withholding rates

The IRS has ruled that an employer may use the reduced tax rates of Code Sec. 3509 to calculate its liability for income tax withholding and FICA taxes of an employee in prior years who is reclassified after receiving an IRS determination letter The employer is also eligible to make an interest-free adjustment to pay its employee federal income tax withholding and FICA tax liability for those years.

Employee status

Either a worker or an employer may file Form SS-8 with the IRS to request a determination or ruling letter regarding a worker's status for federal employment tax purposes. The process, however, does not constitute an examination (audit) of any federal tax return.

If the IRS determines that the worker is an employee, the employer will generally be liable for any resulting underpayment of employment taxes. At any time, including throughout the determination process, the employer may reclassify a worker as an employee and resolve any resulting employment tax liability with the IRS.

Reduced rates

Reduced rates of tax may apply under. Code Sec. 3509 for employers in certain situations involving misclassification of workers. To be eligible, the employer must have treated the worker (without intentional disregard) as a nonemployee for purposes of both income tax withholding and FICA tax. The employer must also have treated the worker as a nonemployee for purposes of information reporting.

Under Code Sec. 3509, the employer's liability is generally reduced to 1.5% of wages for federal income tax withholding, and 20% of the employee's portion of the FICA tax. If the employer failed to file Form 1099-MISC for the worker, the percentages are doubled. The employer remains liable for the full amount of its share of FICA taxes.

Code Sec. 3509 and its legislative history are silent as to whether the reduced rates apply only if the reclassification occurs pursuant to an audit by the IRS and only to a prior tax year. In response, the IRS has held that if an employer meets the requirements of Code Sec. 3509 the reduced rates may be used where the employer has become aware of a misclassification after receiving a determination letter from the IRS through the Form SS-8 process.

However, the reduced rates may only be used to correct a failure to withhold employment taxes for a prior year. They do not apply where the employer discovers a misclassification during the calendar year. This is because the employer can remedy the failure before the year ends.

Adjustments to pay

Code Sec. 6205 and its accompanying regulations permit an employer to correct their employment tax underpayments without incurring any interest, if the error is timely reported and the tax is timely paid. Like Code Sec. 3509, however, nothing limits employers to making interest-free adjustments solely in the context of an audit.

As a result, the IRS has held that if an employer meets the requirements of Code Sec. 3509, the employer is eligible to make an interest-free adjustment in paying its employee FICA tax and federal income tax withholding liability for prior years, as determined using the reduced rates, when the employer is reclassifying the worker after receiving an IRS SS-8 determination letter. (IRS Chief Counsel Advice 200825043, June 23, 2008; IRS Letter Ruling 200825043, May 13, 2008.)

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