Worker Misclassification: Why the IRS Cares & You Should Too

The U.S. Internal Revenue Service (IRS), along with many other federal and state agencies, is increasingly concerned about proper worker classification, as well as rampant worker misclassification. With the explosive growth of the independent workforce and the gig economy, regulatory interest and scrutiny of employer practices will only increase.

Some Background on Worker Misclassification

Almost every business has regular employees. With each paycheck, the business withholds their payroll taxes and pays that amount to the IRS. At the end of the year, the employee gets a W-2 form reflecting those withholding taxes, Social Security taxes, etc. that have been paid to the government on their behalf. In addition to these employee payroll taxes, the employer also pays taxes to the government.

Many businesses also utilize another category of workers, classified as independent contractors. These workers are paid differently. They are paid a gross amount and they are responsible for making their own tax deposits to the IRS. The company reports these earnings to the worker and to the government via a 1099 form at year end.

Here’s the challenge for the IRS: They much prefer to collect income taxes from one source, the employer. This is what happens with W-2 employees. For independent contractors, reported via Form 1099, the IRS must collect income taxes from each worker individually. This creates an obvious administrative burden for the IRS to not only collect the payment, but also scrutinize individual tax returns to ensure deductions and tax payments are correct. It can often result in reduced collections, as some workers have spent the money that should have gone toward making their estimated tax deposits.

To fix this administrative burden and increase collections, the IRS (much like regulatory partner, the Department of Labor) has a strong bias toward workers being classified as employees versus independent contractors.

If the IRS decides to investigate a company’s classification practices, it can do so retroactively—making the employer go back up to three years. In the event they find worker misclassification, ther IRS can require a company to pay all of the independent contractor’s taxes as if they had been an employee of the company, plus adding penalties and interest, even if the worker has already paid those taxes. There is also risk to the worker, as a reclassified independent contractor may have pre-tax deductions (such as a home office, SEP-IRA, etc.) disallowed and be forced to submit amended tax returns for the years in question.

Why is worker misclassification an issue? Why do federal and state agencies care about workers who are improperly classified as independent contractors?

Worker Classification Financial Incentives

Employers might elect to classify workers as independent contractors in order to:

  • Save on the employer’s portion of Social Security and Medicare payroll taxes.
  • Not have to include the worker in the company’s healthcare and retirement plans.
  • Not have to pay state unemployment taxes.
  • Allow for easier termination of a contract for services rather than having to fire an employee.

The IRS wants workers to be classified as employees because it results in:

  • Speedier tax receipts. Employers submit payroll and income taxes to the IRS on a monthly basis. Independent contractors only submit taxes on a quarterly basis.
  • Increased tax receipts. Employees cannot deduct from their income business expenses. Independent contractors can. This leads to lower tax revenue from an independent contractor.
  • Lower cost of audits. Because employers effectively take care of an employee’s tax computation, there is not much concern about potential tax evasion. But because independent contractors compute their own taxes and are able to deduct business expenses, the IRS must commit resources to audit their returns.

Information Sharing and Cascading Risk

Unfortunately, it can get even worse for a company that has been targeted by the IRS. The IRS often shares its reclassification audit information with other federal and state agencies. As a result, a company could also receive a supplemental audit from another state agency seeking to reclassify workers for state tax or unemployment purposes. In addition, the U.S. Department of Labor may want to reclassify the workers in question, further exposing a company to wage and hour scrutiny.

These reclassifications can also trigger a number of related issues such as immigration scrutiny, worker’s compensation liability, federal and state discrimination laws, etc.

Worker misclassification claims are often started by a disgruntled worker. They are typically triggered in one of three ways:

  1. The worker files for unemployment with the state. After learning that only employees, and not independent contractors, are entitled to UI, they claim they should have been classified as an employee.
  2. The worker is injured during their project and files for workers compensation. If they haven’t been paying into a workers compensation fund as self-employed worker, then an agency will typically question the worker classification.
  3. The worker decides to proactively file an IRS SS-8 seeking worker classification. These forms are a significant source of field audits for the IRS.

Background on Independent Contractor Misclassification

The issue of worker misclassification has been around for years. From a federal tax perspective, the question of whether a worker is an independent contractor or employee is decided on some common law issues, as well as IRS regulations. The IRS views all workers as potentially one of the following types: independent contractor, employee, statutory employee, or statutory nonemployee.

Statutory employees include certain drivers (those who distribute meat, vegetables, fruit, or bakery products; beverages other than milk; or laundry or dry cleaning services for their principal, and who meet other requirements), life insurance salespeople, home workers and other salespeople.

Statutory nonemployees include qualified real-estate agents and direct sellers. They are treated as independent contractors.

For all other workers, employers, as instructed by the Internal Revenue Code, must first look to common-law principles and then to the IRS’s 20-point checklist to help them make a decision. The IRS has identified three categories of evidence that may be relevant in determining whether the requisite control exists under the common law test and has grouped illustrative factors under these three categories:

  1. Behavioral control
  2. Financial control
  3. Relationship of the parties

The IRS emphasizes that factors in addition to the 20 points may be relevant, that the weight of the factors may vary based on the circumstances, that relevant factors may change over time, and that all facts must be examined. Furthermore, they stipulate that no one factor will determine the outcome, but rather the “preponderance” of evidence.

If the employer can’t decipher this confusing topic, they (or, as noted above, the worker!) can file a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS and the IRS will make a decision for them!

If an employer commits worker misclassification regarding an independent contractor, without reasonable basis, then the employer will be liable for non- or under-withheld income and employment taxes, as well as possible penalties and fines if the act was willful or egregious.

Conclusion

The bottom line is the IRS (like the DOL and many state agencies) prefers workers to be classified as employees. The burden of proving that a worker is an independent contractor rests on the employer. Fortunately, businesses can leverage independent contractor compliance and engagement experts, like TalentWave, to build and manage a program which properly classifies every independent worker. Quality solution providers will not only provide indemnification for the client, but also audit defense in the event the IRS or any other agency comes knocking on the door.

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