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, saving the business 7.65% of wages employers must pay for Social Security and Medicare taxes, and additional amounts for 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

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 suspect businesses are misclassifying workers if the business files large numbers of Form 1099-MISC, Miscellaneous Income or Form 1099-NEC, Nonemployee Compensation to report payments made to independent contractors, especially if the business is a type that usually uses employees.

The IRS has a special Employment Tax Examination (ETE) program that focuses on certain 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 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 incur large back taxes and penalties. The IRS can order a business to pay all the employment taxes, including the employees' share of the misclassified workers, + a penalty that can range from 12 to 35% of the tax bill.

Section 530 Relief from Employment Taxes

Section 530 of the 1978 Revenue Act only applies when a business treats an individual as an independent contractor, but the IRS wants to reclassify the worker as an employee. Section 530 provides a safe harbor that lowers 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 (reporting consistency) and by treating all similar workers as independent contractors (substantive consistency).

A reasonable basis for misclassification relies on:

• court decisions, IRS rulings, written IRS advice;
• a past audit that did not incur any employment tax liability for workers who were working as independent contractors;
• professional advice of an attorney or an accountant;
• the industry itself has a long-standing practice of classifying its workers as independent contractors, such as taxi drivers;
• at least 25% of businesses within an industry treat their workers as independent contractors;
• or any other reasonable basis for treating the worker as an independent contractor.

However, the business owner must request relief while either being audited or appealing an IRS decision.

The IRS offers 3 types of deals under the CSP:

• taxes will be assessed on past misclassifications;
• the IRS will forgive prior years if the most recent year of unpaid employment taxes because of the misclassifications is paid; or
• 25% of any tax deficiency assessed after an audit must be paid.

Moreover, the employer must agree to classify the workers as employees, and the IRS will monitor the business for 5 years afterward to ensure those policies are carried out. The type of deal a business can expect depends on the auditor or appeals officer, and the reason for the misclassification.

If there is doubt about a worker's status, a business should issue a Form 1099-MISC or Form 1099-NEC; otherwise, a penalty of $50 may be assessed for each Form 1099 not issued if the payment to the independent contractor exceeded $600 in 1 year. Another potential risk of not issuing 1099s is that the business can be assessed all the income tax not paid on those earnings for each worker who did not receive a 1099.

A business could 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, the business must pay all the taxes for those months. In any case, if the classification is not clear (otherwise why would the business ask the IRS to classify its workers), the IRS will almost certainly classify them as employees since that is what the IRS prefers — more tax revenue!

Voluntary Classification Settlement Program (VCSP)

The VCSP is a voluntary IRS program allowing employers, who may be uncertain about their workers’ status, to reclassify their nonemployees as employees by filing Form 8952, Application for Voluntary Classification Settlement Program, agreeing to treat their nonemployees as employees thenceforth to receive partial relief from federal employment taxes. The business must have reported its nonemployees consistently by issuing the appropriate Form 1099s to all workers doing the same type of work before filing Form 8952.

Form 8952, Application for Voluntary Classification Settlement Program must be filed at least 120 days before the reclassification takes effect.

A business under IRS audit may apply for the VCSP but not if the audit of it or any of its affiliates is under an employment tax audit or a previous IRS reclassification is being contested in court. A business under an employment tax audit may apply for the Classification Settlement Program (CSP), which is like the VCSP.

The VCSP agreement requires the business to pay about 10% of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year, but there would be no liability for otherwise applicable interest and penalties.

Acceptance into the VCSP requires the business to sign a closing agreement with the IRS to finalize the VCSP terms and to pay the amount due under the closing agreement. The assessed tax is 10% of the amount calculated under Section 3509(a), equal to 10.68% of the compensation up to the Social Security wage base paid in the previous tax year and 3.24% for compensation above the wage base. Section 3509 lowers the liability for employment taxes.

Because the VCSP is a federal program, a major risk for this voluntary conversion is that states may look at the reclassification as evidence that the workers were employees, so they may assess their own taxes and penalties for the misclassification.

Appealing a Misclassification Decision

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

Viable grounds for winning an appeal include:

• The safe harbor rule applies, especially if there is an industry standard where at least 25% of other businesses in the same type of industry are classified as independent contractors.
• The business was audited before, but the IRS did not challenge the classification of the workers, even though the business is still in the same line of business with the same types of workers. However, the IRS could argue that the IRS auditor didn't properly consider all the factors differentiating employees from independent contractors because it was not the focus of the audit.
• The business could offer to treat the workers as employees henceforth if the IRS will forgo the taxes and penalties on the disputed misclassification; the IRS may accept if the worker status is not clearly established by the facts.

Updates

Rev. Proc. 2022-13 allows a business to seek a review by the Tax Court by filing a petition with the court to challenge a worker reclassification by the IRS, if the IRS reclassified one or more individuals performing services for the business, during an audit of the business, as common-law employees rather than independent contractors. The IRS will issue a formal Notice of Employment Tax Determination Under IRC 7436, but the business does not need to wait until receiving this notice to seek a review by the Tax Court.