Frequently I run into employers who do not want pay payroll tax and decide to have independent contractors. It really isn’t as simple as a decision not to pay payroll taxes there is a set of rules that must be followed to be allowed to classify workers as independent contractors. What employers need to know is that misclassifying employees as nonemployees or independent contractors has substantial financial penalties as the result of not withholding income tax, failing to withhold and pay employment taxes, and failing to file the correct reports and returns with the IRS, Social Security Administration (SSA), and state government agencies. The IRS penalty for unintentionally failing to withhold federal income tax is 1.5% of the wages paid. This assessment is doubled to 3% if the employer failed to file an information return (Form 1099-MISC) for the worker with the IRS. The IRS penalty for unintentionally not withholding the employee’s share of Social Security and Medicare taxes is 20% of the employee’s share of the tax. The penalty is doubled to 40% if the employer failed to file an information return for the worker with the IRS. If an employer intentionally misclassifies the worker as an independent contractor, even after determining that an employer-employee relationship exists, the above penalties do not apply, and the employer is liable for the full amount of federal income tax that should have been withheld, and 100% of the employee’s and employer’s share of Social Security and Medicare taxes. An employer misclassifying workers will also be subject to state penalties.
Retroactive employment benefits. An employer that misclassified workers as independent contractors may have to retroactively pay employment benefits in addition to employment taxes. In 1996, a federal appeals court held that Microsoft Corporation, which had agreed to reclassify “freelancers” as employees after an IRS employment tax audit, also had to include the misclassified workers in its §401(k) plan and §423 employee stock purchase plan.
Increased enforcement efforts. The IRS has increased its enforcement efforts in this area. The 1099 Matching Program targets those individuals who file only one Form 1099-MISC with their personal income tax return. A person receiving payments from only one company may well be an employee, rather than an independent contractor. The IRS may also closely scrutinize a situation where a worker receives a Form 1099 from the same company over multiple years.
Forty state workforce (unemployment) agencies have signed a memorandum of understanding with the IRS to share the results of employment tax examinations. Many times an employer’s worker classification problems begin after someone who has been treated as an independent contractor stops receiving work and files a claim for unemployment benefits.
What is the risk to the employee if they file for a determination of worker status and it is found that the employer knowingly misclassified the employee? Will the employee/ind contractor be penalized even if they paid income taxes, etc. as self-employed ind contractor? Will the IRS look at whether the employee knew or should have known?
If it is determined that the independent contractor should have been an employee, the employer will have to file corrected W2’s and the employee will have to file corrected tax returns. The employee is assessed a penalty from the IRS but the correction of the the tax return could cause additional taxes to be paid or depending on the timing if a refund was due the employee might not receive the refund.