Small and large businesses alike often classify certain workers as independent contractors rather than employees. Sometimes the belief that the workers are contractors is genuine, because of the type of work or industry practice. Other times, businesses classify workers as contractors in an attempt to save money, since employers are not required to withhold income or payroll taxes from contractors’ earnings or reimburse contractors for certain employment-related expenses. However, the IRS is aware that many workers are misclassified as independent contractors when they should be treated as employees, and often pursues back taxes and penalties against employers who misclassify their workers.
Know the Rules. The IRS has developed a number of factors to determine whether a worker should be classified as an employee or independent contractor. The relationship of employee and employer exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work, but also as to the details and means by which the result is accomplished, based on the facts and circumstances. The factors to make this determination include: (i) instructions, (ii) training, (iii) integration, (iv) services rendered personally, (v) hiring, supervising, and paying assistants, (vi) continuing relationship, (vii) set hours of work, (viii) full time required, (ix) doing work on employer’s premises, (x) order or sequence set, (xi) oral or written reports, (xii) payment by hour, week, month, (xiii) payment of business and/or travel expenses, (xiv) furnishing of tools and materials, (xv) significant investment, (xvi) realization of profit or loss, (xvii) working for more than one firm at a time, (xviii) making service available to general public, (xix) right to discharge, and (xx) right to terminate. Treas. Reg. 31.3121(d)-1(c) (FICA), 31.3306(i)-1(b) (FUTA), and 31.3401(c)-1(b) (withholding income tax). Note that industry practices, preference of parties, and negotiated contract are not included in this list – these factors, while relevant, typically are not included when the IRS makes its determination.
The Risk of Misclassification. There are a number of risks that arise when an employer misclassifies workers. The IRS may audit an employer and any affiliates to determine whether it is correctly treating all of its workers as independent contractors or employees. If the IRS determines that a worker is an employee by applying the factors listed above to the particular facts and circumstances, three years or more of delinquent employment taxes, penalties, and interest may be assessed. While an employer can appeal an IRS audit determination, the cost of appealing to IRS Appeals Division or Tax Court can be high. Moreover, the employer may face a domino effect of repercussions from other agencies who may assess liabilities against the employer (such as the Department of Employment Security or the Department of Labor) and/or file a lawsuit to collect the amount due. In addition, employers who inappropriately treat workers as independent contractors risk lawsuits and whistleblower actions from workers directly, seeking additional compensation such as overtime pay or required reimbursements under state and federal employment laws. As such, it is crucial that every employer closely evaluate the status of its workers and weigh the risks when determining whether workers are independent contractors or employees.
Getting Back Into Compliance. A business believing it may have misclassified workersin the past should, at the very least, begin classifying workers prospectively, starting today. While this does not remove the risks mentioned above for past violations, it clears the path for a compliant future. For employers who want to eliminate the risk entirely, the IRS offers a “Voluntary Classification Settlement Program” (“VCSP”) to allow businesses an opportunity to reclassify their workers as employees for future tax periods with partial relief from past due federal employment taxes. To participate in the VCSP the taxpayer must meet certain eligibility requirements, apply to participate in the VCSP by completing certain forms and providing documents, disclose all requested information to the IRS, and enter into a closing agreement with the IRS. Similar relief is available to taxpayers who are already under audit for misclassifying workers.
Taxpayers are eligible for VCSP when they are currently and consistently treating all or a class of workers as independent contractors for at least the three most recent years, and they want to prospectively treat the workers as employees. They must fully cooperate with the VCSP investigation, including making a complete and truthful disclosure. Taxpayers must agree to treat all or a class of workers as employees for future tax periods and pay 10% of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year. In exchange, the taxpayer will not be held liable on the full amount of employment taxes due for the most recent tax year or any previous tax years, and the taxpayer will not be liable for any interest and penalties on the amount due. In addition, the IRS will not audit the taxpayer with respect to the worker classification of the workers being reclassified under the VCSP for prior years.
Where to Get Help. Businesses wishing to obtain guidance on whether their workers should be treated as independent contractors or employees for tax purposes, or wishing to participate in the IRS’s VCSP, can seek assistance from experienced tax professionals such as GCK. GCK’s tax attorneys have guided many employers through the process of coming back into compliance with federal tax laws.