Worker classification has been a point of contention between employers and the Internal Revenue Service (IRS) for decades. Historically, for employers with workers improperly classified as independent contractors, the typical consequence is tax exposure for the amount of federal payroll taxes that should have been withheld had the worker been construed as an employee. In a recent study, the IRS revealed that misclassified workers result in an annual tax loss of $2.7 billion.
Over the past several months, however, the need to ensure appropriate worker classification has increased. The US Department of Labor (DOL) website remarks that an employer with misclassified independent contractors has an unfair competitive advantage over an employer that is compliant with the rules. Employers in all industries are being scrutinized as never before, as federal and state agencies are ramping up their enforcement efforts. What does this mean for your organization?
Elevated Enforcement and Exposure
Recently the IRS and DOL agreed to share information about employees misclassified as independent contractors. In addition to recovering lost tax dollars, the agencies seek to improve compliance with federal labor and employee benefits laws.
In support of the effort, DOL has hired more investigators. This means heightened exposure for employers with workers misclassified as independent contractors under the Fair Labor Standards Act for payment of overtime pay and under ERISA for pension benefits and welfare benefits such as healthcare coverage.
Elevated exposure for organizations with misclassified independent contractors doesn’t stop with the federal government. The IRS and DOL have entered into agreements with numerous states for sharing worker misclassification information. This means additional exposure for state income tax withholding, unemployment compensation taxes, and workers’ compensation benefits. Furthermore, the pervasiveness of worker misclassification has attracted class action lawyers seeking to recover unpaid employee benefits and overtime pay.
A worker may be properly classified as either an employee or as an independent contractor, based on the facts and circumstances surrounding the relationship. An employee is an individual who performs services for an organization and is subject to the organization's control regarding what will be done and how it will be done. An independent contractor is an individual who performs services for an organization, but the organization only controls the result of the work.
The IRS considers three categories of evidence when determining whether a worker is an employee or independent contractor: behavioral control, financial control, and the type of relationship. With behavioral control, the type and degree of instructions given to the worker by the organization need to be evaluated as well as any training provided by the organization. Also, the way in which the organization evaluates the worker’s performance can have an impact on the classification. The key fact to consider is whether the organization retains the right to control the worker regardless of whether that organization actually exercises that right.
There are several questions to ask when evaluating the financial control. Is the worker free to seek opportunities to perform the services elsewhere in the market? Does the worker assume the risk of profit and loss? Is the worker paid by the hour or by the job? Is the worker responsible for making a significant investment in tools and supplies? Does the worker incur unreimbursed business expenses?
In evaluating the type of relationship between the organization and the worker, key information to consider is the permanency of the relationship, whether employee-type benefits are provided to the worker, and whether the services provided represent the key activity of the organization.
The IRS typically considers corporate officers to be employees. However, a corporate officer who does not perform any services or only minor services, and neither receives nor is entitled to receive any remuneration is considered not to be an employee of the corporation. A director of a corporation in his capacity as such is not an employee of the corporation.
For additional guidance on the proper classification of a worker, you can refer to Revenue Ruling 87-41, in which the IRS has provided a list of twenty factors used to determine whether sufficient control exists to create an employer-employee relationship. In addition, Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) can be used as a self-audit tool. Please consult your tax advisor before submitting an SS-8 to the IRS for an official determination.
Addressing Misclassified Independent Contractors
An organization with potentially misclassified workers may be eligible for IRS Section 530 Relief. Section 530 Relief refers to a section of the Revenue Act of 1978 under which organizations will not owe employment taxes for misclassified workers if certain requirements are met. First, the organization must have a reasonable basis for treating the workers as independent contractors. Reasonable basis can include judicial precedent, prior audit results, or a long-standing industry practice. In addition, the organization must show that it has treated all workers doing similar work consistently and that all required federal tax returns (Form 1099) must have been filed.
The IRS-sponsored Voluntary Classification Settlement Program (VCSP) may be a relatively low cost solution for employers with misclassified workers. Organizations can apply for the VCSP in order to properly classify workers for future tax periods. Organizations would be subject to pay 10 percent of the prior year federal payroll taxes (calculated at lower than typical rates) with no interest or penalty charges. There are several eligibility requirements for the VCSP. For example, the organization must currently be treating workers as nonemployees, it must be filing 1099s for all nonemployees, and the organization cannot be currently under audit. Some employers have been reluctant to pursue the VCSP because it does not insulate them from the DOL, states, or claims by current or former misclassified workers for wages and benefits.
Also, employers should shore-up their processes for classifying workers. For larger employers with no centralized hiring process this is a more difficult undertaking. However, improved organization communication, education for hiring managers and internal controls for determining and monitoring the proper worker classification can mitigate exposure.
Exposure for failing to classify workers appropriately is steep. The IRS can order offenders to pay all employment taxes that should have been paid, plus penalties and interest based on a percentage of the tax bill. The amount of the payment, including penalties and interest, can vary significantly depending upon whether the organization has consistently reported similar workers and filed all required returns timely.
For more information, contact your Plante Moran engagement team member.