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Misclassifying independent contractors and other payroll tax issues


A misclassified independent contractor can lead to unplanned employment tax liabilities. A close review of the position duties is often needed to get a classification correct.

As the economy continues its lackluster performance, businesses look for more ways to cut costs. Many companies are still nervous about hiring full-time employees even as orders increase. Contract and vendor relationships may bridge the gap. However, companies can easily misclassify employees as 1099 independent contractors and face potentially large employment tax penalties.

Employers must withhold federal income tax, Federal Insurance Contribution Act (FICA) tax (which includes a social security tax of 12.4 percent split between the employee and employer and Medicare of 2.9 percent split similarly) and state income tax for their employees. These trust fund payments are then paid to the Internal Revenue Service on the behalf of the employee.

Some business owners run into trouble when they use the trust fund payments to cover operating losses or pocket the proceeds for personal expenses. Other payroll accounting shifts can also prompt an IRS investigation.

In a recent IRS case against a truck company owner prosecutors alleged he failed to deduct FICA taxes from the paychecks of his employees for three years. To conceal the fact that he was not withholding the taxes, he classified some wage payments as reimbursements for “road expenses.” After a conviction, the court sentenced the owner to a prison sentence of 12 months and a day.

A business owner can also get into trouble for failing to classify workers properly.

Misclassification: Another means to avoid tax withholdings

Employers can reduce administrative burdens by paying a worker on a 1099. The employer withholds no taxes and does not need to contribute a percentage toward FICA. The worker must file a schedule C and track business expenses.

In many fields, there is routine misclassification of workers. Constructions workers for instance often receive their pay as independent contractors. But many in the construction industry work for others and are not truly self-employed.

The common law differences between an employee and an independent contractor relate to control and independence. There are three main categories:

  1. Behavioral – Does a company tell the worker what to do and when? Is a company controlling how the worker completes a project?
  2. Financial – Could the worker lose money on a job? Who provides tools and supplies?
  3. Type of Relationship – Is there a contract or typical employee benefits like vacation pay or health insurance? How long will the relationship continue?

When the employer directs the daily work assignments the relationship is likely that of an employee. Independent contractors usually will provide bids and complete more limited scope projects – an internet website, new roof or consulting services, for example.

If the IRS discovers that workers have been misclassified, the employer is usually liable for employment taxes. Several years ago, the IRS started a program called the Voluntary Classification Settlement Program that allows employers to reclassify workers for future years and receive partial relief from the employment taxes.

An experienced taxation attorney can assist in making sure worker classifications are correct and explain the VCSP process when workers have been misclassified. If the IRS seeks to audit or investigate your company, it is also very important to consult a tax lawyer for guidance.

Keywords: Employment taxes, misclassified workers, VCSP