Worker misclassification is a perennial issue for the Internal Revenue Service and state taxing authorities due to the perception that many employers are not properly classifying their workers.
By avoiding labeling their workers as employees, employers also avoid paying minimum wages, overtime, payroll taxes, worker’s compensation, unemployment, Social Security contributions, health benefits, paid leave, 401(k) benefits and unpaid leave under the Federal Family and Medical Leave Act. And workers have some benefits to being considered independent contractors, such as the ability to deduct certain business expenses that are not available to employees, the ability to set up their own retirement plans, and the fact that they are not subject to withholding. Of course, many workers want to be considered employees so they can get the benefits due employees, such as vacation pay, overtime pay and health insurance.
It’s easy for an accountant to make a mistake because there is no bright-line test to judge whether a worker is an employee or an independent contractor. The IRS has used a 20-factor test based on common law principles, which it has also shortened into a three-part test focusing on behavioral control, financial control, and the relationship of the parties. The IRS still uses both tests, and states may follow the federal tests or have their own, more restrictive rules.
If a business classifies a worker as an independent contractor and the worker is found to be an employee, the business is responsible for the taxes it failed to withhold, as well as the employee’s share, plus interest and penalties over the years the misclassification was claimed. With several employees over several years, this can quickly become a nightmare.
For those employers losing sleep over the potential consequences of a misclassification, the IRS still has a Voluntary Classification Settlement Program. The mechanics are simple: The employer files Form 8952, Application for Voluntary Classification Settlement Program, and sends it to the IRS, which does an eligibility check and prepares a closing agreement. The taxpayer signs it and sends it back with the amount owed, and begins prospectively treating the workers in question as employees.
It allows the employer to pay a reduced fine or penalty if they agree to reclassify and start to withhold and pay tax on a prospective basis. Under the program, the amount owed is just over 1 percent of the wages paid to the reclassified workers for the past year, with no interest or penalties and no admission of guilt.
The prerequisites to filing Form 8952 include consistency in treating the workers and any similar workers as independent contractors, and filing all required 1099s for them in prior years. Section 530 of the Revenue Act of 1978, which is not a part of the Internal Revenue Code, provides a safe harbor for employers. The third step is finding a reasonable basis to treat them as independent contractors.
To add to the complexity in dealing with the issue, DOL standards, and some state rules, are stricter than IRS rules.
Startup companies are vulnerable to misclassification. They like to employ independent contractors who would not pass the test. The worker may want it that way, and the business perceives it as a less expensive way to start the business. But down the line when they want to sell, investors or potential acquirers who do their due diligence will have a reduced interest in investing or will seek a reduction in the price due to the risk of claims by workers or audits by agencies.
For employers faced with proving their workers were independent contractors, a recent ruling by the Tax Court might help: Mescallero Apache Tribe v. Commissioner, 148 T.C. No. 11. Where the employer was unable to locate the former workers, the court ruled that such employers can access IRS records of the reclassified workers’ tax returns to ascertain whether the workers themselves had paid income tax on their earnings. Such information is generally confidential, but in a case of first impression, the court ruled that an exception under Code Section 6103(h)(4) applied.
If the worker has paid income tax, the employer’s liability would be reduced by the amount the employee paid. The court noted that one of the factors in worker classification cases is whether or not the workers in question viewed themselves as independent contractors or employees. The fact that they paid taxes would be evidence that they viewed themselves as independent contractors. And, of course, to the extent that they paid taxes, it would absolve the employer from liability on the employee’s income tax withholding, and on a host of other liabilities: FICA, FUTA, workers’ compensation, vacation and sick pay, minimum wage violations, and overtime pay.
For assistance in dealing with back taxes, tax delinquencies, installment agreements or offers in compromise, no matter what the problems was, call Jeffrey R. Siegel, your Kansas City Tax Attorney.