The IRS and Department of Labor’s Focus on Worker Classification

 

In Brief

Classifying a worker as an employee or an independent contractor has a significant effect on the cost of employing that individual. For this reason, the IRS and Department of Labor pay close attention to worker classification issues to ensure that employers are making the right determinations.  Intentionally or not, many workers in the United States are classified as independent contractors (IC). In classifying a worker as an IC instead of an employee, putative employers can eliminate the following expenses:

  • The employer’s share of Social Security (FICA) and Medicare taxes
  • Overtime and minimum wage payments
  • Employee health insurance premiums
  • Employee retirement benefits, vacation, holiday, and sick pay
  • Other employee fringe benefits, such as stock options
  • Federal and state unemployment compensation taxes (FUTA and SUTA)
  • Workers’ compensation insurance premiums.

Federal and state regulators take this issue very seriously and have recently re-energized their efforts to challenge worker classification. Unreported or underreported employment taxes contribute to the overall federal tax gap (Tax Gap Estimates for Tax Years 2008–2010, IRS publication, http://bit.ly/2Lza1BM). Federal employment withholding taxes represent nearly 70% of all federal tax revenue to be paid to the IRS, which seeks back taxes and penalties from employers that wrongly treat workers as self-employed contractors. At the same time, and sometimes in partnership, the U.S. Departments of Labor and Justice and their counterparts at the state level are involved in ensuring that workers are properly classified by their employers, as is most recently evident in the rapidly growing “sharing” or “gig” economy created by various freelance service opportunities such as Uber, Lyft, and Grubhub.

 

Federal Ramifications

Federal penalties for worker misclassification can be severe. Ramifications vary depending on the DOL or the IRS’s determination of whether the misclassification was unintentional, intentional (willful), or even fraudulent. If the mis-classification was unintentional, the employer faces penalties based on the fact that all payments to misclassified ICs are reclassified as wages. If the IRS suspects intentional misconduct or fraud, however, it can impose additional fines and penalties; for example, penalties that include 20% of all the wages paid, plus 100% of the FICA taxes—both the employee and employer’s share. Criminal penalties are assessed for each misclassified worker, and the court can impose a prison sentence as well. In addition, the persons responsible for withholding payroll taxes may be held personally liable for any uncollected or unremitted tax under the responsible person penalty statute [Internal Revenue Code (IRC) section 6672] and its state counterparts. The IRS administers tax-related violations, while the DOL enforces federal and sometimes state labor laws, typically pursuant to the Fair Labor Standards Act (FLSA). Willful violators may be prosecuted criminally and fined up to $10,000 by the DOL, or imprisoned for a second conviction (http://bit.ly/2Vb5c64).

 

Recommended Action for Employers

Employers should think carefully about entering into IC relationships that last long-term or indefinitely. They should periodically conduct audits of all positions and review the requirements for an employee versus an IC; in some cases, the relationship between a contractor and employer may change over time. For example, an employer may hire a contractor to complete a specified project with a set deadline, but find the project has become more of a long-term activity. As a result, it may be more appropriate for the contractor to be reclassified as an employee. Another best practice is executing a separate contract with an IC for each project completed so as to emphasize the independent nature of the relationship. Outside counsel (or a CPA under a Kovel agreement) should consider recommending that potential employers use IRS Form SS-8 as an informal checklist for determining whether a particular worker or class of workers should properly be classified as contractors or employees.