Misclassifying Workers as Independent Contractors

Businesses want to hire labor as cheaply as possible. That often means classifying their workers as independent contractors rather than as employees. Hiring independent contractors rather than employees saves the business the 7.65% of an employee's wages for Social Security and Medicare taxes, federal and state unemployment taxes, and other required expenditures for employees, such as workers compensation insurance and employee benefits. There is also a small cost in keeping administrative records for employees and administering and withholding a portion of employees' pay to make periodic tax deposits. Additionally, the tax penalties associated with not depositing employment taxes on time is proportional to the amount not deposited, so having fewer employees reduces these hefty penalties. The IRS charges 2% of any tax deposits made even 5 days late and up to 15% for payments not received within 10 days of an IRS notice.

How the IRS Finds Misclassifications

Article continues below this space.

The IRS finds out about potential misclassifications to investigate by relying on business audits. Whenever a business is audited, the IRS always investigates payments made to independent contractors. It may also suspect businesses are misclassifying workers if the business files large numbers of Form 1099-MISC, Miscellaneous Income, which are used to report the payments made to independent contractors, especially if the business is a type that usually uses employees.

The IRS also has a special Employment Tax Examination (ETE) program, which focuses on specific types of businesses that frequently misclassifies workers, such as temporary employment agencies, nursing registries, and building contractors.

Another method by which the IRS becomes alerted to possible misclassifications is when the independent contractor files for unemployment from another job and lists his work as an independent contractor. State employment agencies will investigate these as a possible misclassification, since they, too, can collect back taxes and assess hefty penalties for misclassifications. If the state successfully reclassifies independent contractors as employees, it will notify the IRS, who will also want to collect back taxes and penalties.

Penalties for Misclassifying Workers

The IRS actively seeks misclassifications because they often result in large back taxes and penalties. The IRS can order a business to pay all of the employment taxes, including the employees' share of the misclassified workers, plus a penalty that can range from 12 to 35% of the tax bill.

IRS Classification Settlement Program

The IRS offers a safe harbor called the Classification Settlement Program (CSP), which greatly lessens both taxes and penalties if the business owner had a reasonable basis for treating the workers as independent contractors and if they were, in fact, treated as independent contractors by sending them 1099 forms and by treating all similar workers as independent contractors.

Section 530 of the 1978 Revenue Act, which encodes the safe harbor rule, provides that a reasonable basis for misclassification can include reliance on:

However, the business owner will not be offered a CSP unless he requests it while either being audited or appealing a decision by the IRS.

The IRS offers 3 types of deals under the CSP:

Moreover, the employer must agree to classify the workers as employees in the future, and the IRS will monitor the business for 5 years afterward to ensure that the policies are carried out. The type of deal the business will be given will depend on the auditor or appeals officer, and the reason for the misclassification.

Whenever a business has any doubt about issuing a Form 1099-MISC, they should do so because they could be assessed a penalty of $50 for each 1099 not issued if the payment to the independent contractor was more than $600 in 1 year. Another potential risk of not issuing 1099s is that the business can be assessed all of the income tax not paid on those earnings for each individual who did not receive a 1099.

A business could also ask the IRS to classify its workers by filing Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding. Although this will remove any potential tax liability regarding the classification of its workers, the request can take several months, and if the IRS decides that the workers are employees, then the business will have to pay all of the taxes during those months. In any case, if the classification is not clear (otherwise why would the business ask the IRS to classify its workers beforehand), the IRS will almost certainly classify them as employees, since that is what the IRS prefers — more tax revenue!

Appealing a Misclassification Decision

Article continues below this space.

Although the IRS frequently decides, during an audit, that independent contractors were misclassified, the decision can be appealed before the audit of the business is complete. A reclassification can also be challenged in United States Tax Court. IRC §7436

Viable grounds for winning an appeal include:

Tax Tips: A business can avoid the classification problem by using a temporary employment agency, which handles all of the legal requirements regarding employees, including deducting payroll taxes. However, the temporary employment agencies generally charge a markup for the extra costs, but it may make sense for a business that has a highly variable need for workers.

If a business does decide to hire independent contractors regularly, then it should have an independent contractor agreement on file in its computer systems, so that it can be quickly printed and signed by any independent contractors before doing any work. While a contract will never be determinative of a worker's status, especially if they have the qualities of common-law employees, the contract may be the deciding factor in borderline cases.