A Guide for Worker Classification
By John Pontius, Tax Section Co-Chair
Employers are required to withhold and pay Social Security and Medicare (“FICA”), as well as federal unemployment (“FUTA”) taxes (collectively “Payroll Taxes”) with respect to workers that are classified as “employees” under applicable Internal Revenue Service guidance. However, employers who hire independent contractors avoid these taxes. As a result, many employers are tempted to classify workers, often incorrectly, as independent contractors to reduce their taxes. As set forth below, misclassification of workers can result in significant exposure in the form of back taxes and penalties. This article does not address the state tax issues related to worker classification.
The IRS last estimated the tax gap between taxes owed and taxes collected for worker misclassification in 1984. The IRS estimated this tax gap to be $1.6 billion per year based upon a finding that 15% of employers misclassified 3.4 million workers as independent contractors.
A 2012 Treasury Inspector General for Tax Administration (“TIGTA”) report found that misclassifying a worker with yearly earnings of $43,007 could save the employer $3,710 per year. Over the last three years, IRS audited over 6,000 employers and collected over $10 million in taxes. These audits tend to focus on small businesses in the trucking, home health care, and construction industries.
As the IRS auditors continue to target worker misclassification it is important for employers to properly classify workers from the date of hire. For employers who have misclassified workers, they can seek relief from employment tax liability through Section 3509, Section 530 or through the Voluntary Classification Settlement Program. Starting in 2015, the Affordable Care Act will penalize employers with more than 50 employees if they fail to offer affordable health coverage to full time employees and their dependents. Accordingly, now is a good time for employers to review if they have properly classified their workers.
While the IRS has defined certain workers as statutory employees and statutory non-employees, most workers are classified under the common law. In 1987, the IRS provided 20 common law factors for determining whether an individual is an employee or independent contractor. The primary factor is the amount of control the employer has over the worker. When the employer controls the daily work, the worker is more likely an employee. In 1996, the IRS streamlined the worker classification criteria to three factors; behavioral control, financial control and relationship of the parties. Behavioral control exists if the employer has the right to direct or control how the worker does the work. Financial control is present if the employer has the right to direct or control the business part (i.e. profit or loss) of the work. Relationship of the parties is based upon how the business and workers perceive the relationship.
Relief from Employment Tax Liability
If the IRS retroactively reclassifies independent contractors as employees, it is authorized to assess the employer with federal employment taxes, penalties and interest. Fortunately, the IRS provides several forms of relief for taxpayers with employer tax liability.
For employers with reasonable cause who filed Forms 1099 for erroneously classified independent contractors, Section 3509 of the Internal Revenue Code reduces the tax rate to 20% of the employee’s portion of the FICA taxes. If the employer did not have reasonable cause, the rate increases to 40% of the employee’s portion of the FICA taxes. Section 3509 does not apply if the employer intentionally disregards the requirement to deduct and withhold employment taxes. Also Section 3509 does not provide relief for the employer’s portion of the FICA taxes or FUTA taxes. Going forward, the employer remains responsible for making Social Security, Medicare and federal unemployment tax payments for its employees.
Section 530 of the Revenue Act of 1978 as amended prevents the IRS from retroactively reclassifying independent contractors as employees. It provides employers with a safe harbor from employment tax liability if the taxpayer (1) had reasonable basis for not treating the workers as employees, (2) was consistent in its treatment of the workers as contractors, and (3) consistently filed all information returns (i.e. Forms 1099s) with the IRS. If the employer qualifies for Section 530 relief, it will continue to classify its workers as independent contractors. The major benefit is that the employer continues to avoid making Social Security, Medicare and federal unemployment tax payments for these independent contractors.
For taxpayers that have misclassified their workers as independent contractors, the IRS provides amnesty through the Voluntary Classification Settlement Program (“VCSP”). As a result, employers can resolve their past worker classification issues at a low cost by voluntarily reclassifying their workers or a class of workers. To be eligible for the VSCP, the employer must meet the following requirements: (1) consistently treated workers in the past as independent contractors, (2) filed all Forms 1099 for the workers for the previous three years, and (3) not currently under audit by the IRS, Department of Labor or a state agency concerning the classification of these workers. Note that if the IRS contacts an employer based upon a worker filing Form SS-8, Determination of Work Status, it is not an audit for VCSP purposes.
There are many benefits of the VCSP. The taxpayer pays only 10 percent of the employment tax liability that would have been due for the most recent year had the workers been properly classified as employees. Interest and penalties are waived. Additionally the employer will not be subject to an employment tax audit for worker classification for prior years. Going forward the employer would be responsible for making Social Security, Medicare and federal unemployment tax payments for its employees.
Now Is the Time To Review Worker Classification
As a result of the large tax gap in employment taxes based upon worker misclassification, the IRS will continue to make this issue a priority. The potential consequences of a misclassification are severe. It is important that employers review all worker classifications to reduce their potential audit exposure.
Originally published in the Newsletter of the Bar Association of Montgomery County, Maryland.