You can be personally responsible for not classifying yourself or any other employee as an independent contractor. When the IRS and state taxing authorities find businesses have inappropriately avoided payroll taxes, the taxes, interest and penalties can be severe. In some cases, there can even be criminal liability. Many people try to call themselves or some officer or direct an independent contractor to the corporation, but in reality they are employees. When companies use independent contractors, the IRS frequently will assert that those workers are really company employees.
Your state’s taxing authority also may claim that independent contractors really are employees. If you’re the officer of an S corporation, for example, you cannot issue a 1099 to yourself. You cannot be a contractor to your own corporation. You cannot be an independent contractor as the sole shareholder and officer of your own S corporation. You will end up paying self-employment taxes anyhow if you don’t pay yourself wages, just on all of the income you earn.
You can’t be an independent contractor performing services on behalf of the corporation and still be an officer. An officer/shareholder of a corporation is generally an employee, but an officer who performs no services or only minor services, and who neither receives nor is entitled to receive any pay, is not considered an employee, according to the IRS. Courts have consistently held S corporation officers/shareholders who provide more than minor services to their corporation and receive, or are entitled to receive, compensation are subject to federal employment taxes. The IRS has said over and over again that S-Corporations must pay their shareholder-employees a “reasonable compensation” for services rendered to the company. The courts have consistently found shareholder-employees are subject to employment taxes even when shareholders take distributions, dividends or other forms of compensation instead paying wages.
A director of a corporation may not be an employee of the corporation, but he or she can be one depending upon the specific responsibilities. The employee relationship would be considered as separate from his or her position as a director. Generally, being a mere director without more will not make one an employee of the Company. But, if he or she is managing director or executive director, or is getting a salary for rendering some services, then that person will be considered to be an employee. State law is similar to the IRS rules, but you must check any applicable state laws to know for sure how your state classifies employees.
Because LLC members are not considered employees of the LLC, but rather self-employed, they are not subject to withholding taxes. Instead, each LLC member is responsible for setting aside enough money to pay taxes on his share of the profits. However, an outside manager who is not a member will be considered to be an employee. In general, equity owners of an LLC may not be treated as employees of that LLC. Also, with respect to an LLC that has elected to be taxed as a corporation (either C or S), the members may be treated as W-2 employees of the LLC in this case. The bottom line is that to the extent someone is classified by the IRS or any state taxing authority as an employee of your business, you can be liable for any unpaid employment taxes if you are a responsible party.