The Tax Risks of Misclassifying Employees
Over the last few years, worker classification initiatives have been a top priority for the Internal Revenue Service (IRS), Department of Labor (DOL), and state agencies. In 2011, the IRS and DOL signed a memorandum of understanding in an effort to jointly increase worker misclassification audits. Pursuant to the memorandum, the DOL now refers wage and hour investigations involving IRS employment tax compliance issues to the IRS.
Employers often prefer to hire independent contractors so that the employer can avoid payment of federal and state employment taxes, federal and state unemployment insurance taxes, employee benefits, and workers' compensation premiums. The IRS's concern is that the increasing use of independent contractors in the workplace is leading to a tax gap in lost payroll tax revenue.
While it may seem profitable to label someone as an independent contractor, employers must think twice before doing so because the risks of misclassification are significant. Risks include liability for years of unpaid federal, state and local income tax withholdings and Social Security and Medicare contributions, unpaid workers' compensation and unemployment insurance premiums. In some cases, the employer may even be responsible for unpaid work-related expenses and overtime compensation. Interest and penalties for non-compliance can be levied along with these penalties, leading to economically devastating consequences for businesses.
In addition to the above penalties, beginning in 2015, pursuant to the Affordable Care Act, large employers (i.e., those with 50 or more employees) that fail to provide the minimum required level of affordable health care to an employee will be assessed an additional penalty of $2,000 per employee. Therefore, it is crucial that employers review their classification titles before this provision becomes effective.
The IRS uses a "control test" for purposes of determining independent contractor relationships. While a myriad of factors can be examined under each topic, the three broad categories below constitute the general focus of IRS's control test:
1. Behavioral. Does the employer control, or have the right to control, what the worker does and how the worker completes his/her job?
2. Financial. Does the employer control the business aspects of the worker's job? For example, is the worker paid a salary? Does the employer reimburse for expenese? Does the employer provide the tools required for job completion?
3. Type of Relationship. Does the worker receive employee-type benefits? Will the relationship continue after the work is finished? Is the work a key aspect of the employer's business?
Classification can be a complex and highly fact-intensive issue, but if the answer to most of these questions above is yes, chances are, in the eyes of the IRS, the subject worker is an employee and not an independent contractor.
If you are an employer and are concerned about misclassification, there is a potential relief option. In 2011, the IRS announced its Voluntary Classification Settlement Program (VSCP) which allows certain employers to correctly reclassify independent contractors as employees. In exchange for voluntarily reclassification, the employer pays a penalty of only 10% of the employer's tax liability and will not be liable for any interest or penalties. The employer must, however, agree to treat the worker as an employee in the future and pay the proper taxes.
In order to qualify for the program, the employer must pass three tests: (1) the employer must have consistently treated the worker an independent contractor; (2) the employer must have filed all required Form 1099s for the preceding calendar year; and (3) the employer must not currently be under audit by the IRS, DOL or any state government agency.