IRS and States Target Independent Workers

Companies slash payrolls by calling workers independent contractors; costly to IRS and states.

The Internal Revenue Service and states are cracking down on companies that try to trim payroll cost by classifying workers as independent contractors, rather than full employees. 

In recent weeks Hodges & Hart has fielded various inquiries on the employee vs. independent contractor issue. Though always a questionable practice, it is believed that the economic downturn has had a serious impact and exacerbated the problem.

By designating workers as "independent contractors," businesses can save as much as 30 percent of payroll avoiding unemployment insurance and workers' compensation payments, as well as the employer's share of payroll withholding.

The practice also deprives states of needed income as the jobless rates strain their budgets.

The IRS uses three characteristics to determine the relationship between businesses and workers: 

• Behavioral control
• Financial control
• Type of relationship

The worker’s status is further defined by identifying specific characteristics. The following provides several indicators to consider when evaluating an independent contractor’s status: 

• Free from direction and control
• Has necessary skills and training to complete job
• Has a business location
• Performs services for multiple customers
• Sets own hours
• Not eligible for employee benefits
• Provides own equipment, materials and tools to complete job
• Personally liable for errors and/or accidents
• Files self-employment taxes, receive a form 1099-MISC

It should be noted, the preceding items are not the text of the law or an all-inclusive list, but are meant to provide indicators of an independent contractor’s status.  For further information, read more at: IRS.gov

Employers that misclassify employees as nonemployees or independent contractors will face 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 [Vizcaino v. Microsoft Corp., CA9, 78 AFTR 2d 96-6690, 10/3/96].

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.

The Internal Revenue Service is launching a program that will randomly examine 6,000 companies over the next three years for employee misclassifications.  The federal government estimates it will raise $7 billion through tighter enforcement.

Please contact Hodges & Hart should you be interested in discussing the employee vs. independent contractor issue in further detail.

Internal Revenue Code Circular 230 requires that this is not a reliance opinion.  To ensure compliance with IRS Circular 230, any U.S. Federal tax advice contained in this communication (including any attachments, enclosures, or other accompanying materials) is not intended or written to be used, and cannot be used, by the recipient or any other taxpayer for the purpose of avoiding penalties that may be imposed on the recipient or any other taxpayer; furthermore this communication was not intended or written to support the promotion, marketing of any of the transactions or matters it addresses.  The underlying provisions put forth in IRS Circular 230 are also applicable to all state and local taxing jurisdictions.