Businesses large and small must properly classify their workers as either independent contractors or employees for federal employment tax purposes. Misclassification results when an employer treats a worker,who legally qualifies as an employee as an independent contractor.
Under the Internal Revenue Code, employers must withhold federal income taxes from, and pay Social Security, Medicare, and unemployment taxes on, wages paid to employees, but not to independent contractors. So, employers – especially small businesses – and their workers often seek to describe their relationship as an independent contractor arrangement.
However, worker misclassification costs the Federal government billions of dollars in lost revenue. So, as part of its ongoing heightened enforcement efforts the IRS recently issued further guidance to businesses. In particular, business owners should be aware that the risks of misclassification are great, especially in comparison to the perceived benefit.
Penalties for misclassification can be severe, even if the misclassification is unintentional. In that case, an employer might nevertheless be liable for all of the FICA that it would have had to pay if the employee had been properly classified, plus forty percent of the FICA that the employee would have had to pay, plus one and one half percent of the wages paid to the employee.
Penalties for intentional or fraudulent misclassification are far worse. In those cases, an employer can be fined an amount equal to one hundred percent of the FICA that both the employer and employee should have paid, plus twenty percent of the wages paid to the worker. In addition, the intentional or fraudulent misclassification is punishable by criminal prosecution, with a maximum sentence of five years in prison or a fine of up to $100,000 (for individuals) or $500,000 (for corporations), or both, plus the costs of the prosecution (which can be quite substantial).
So, it is critically important for businesses to classify their workers correctly. The label placed on the relationship by the company is not determinative, and often will have little to do with a worker’s proper classification. Businesses are not left to wander on their own in the dark, however. The IRS has issued some guidelines, and will help with the determination, though business owners should almost never approach the IRS for its “help” on the issue without first consulting a lawyer, an accountant, or both.
The IRS has advised that, in general, “an individual is an independent contractor if the employer has the right to control or direct only the result of the work, not what will be done and how it will be done” (emphasis added).
Ultimately, the determination is extremely fact-dependent, but the IRS has identified three categories for businesses to consider in classifying workers: (1) Behavioral Control; (2) Financial Control; and (3) Relationship of the Parties. Each category includes a list of key factors that serve to aid a business in evaluating its relationships with its workers.
A worker is properly classified as an employee if the employer exercises significant behavioral and financial control over the worker. Some factors that indicate control are: (a) detailed instructions on when and where to work; (b) significant investment in the tools the worker uses to complete the work; and (c) payment of a regular hourly or weekly wage. A worker is also properly classified as an employee if there is evidence of an intent to create an employer-employee relationship. Some factors that indicate an employment relationship are: (a) receipt of employee-type benefits (e.g., insurance, pension, and vacation pay); (b) establishment of written contracts describing the employment relationship; and (c) expectation of a permanent or indefinite working relationship.
Because of the potentially significant consequences of misclassifying a worker, even unintentionally, if the classification question is close, businesses should generally classify and pay workers as employees, notwithstanding the potential increase in short-term costs for both the company and the employee. When in doubt, employers should consult with experienced employment counsel.