Costs of Misclassifying Employees as Independent Contractors Continue to Rise as the IRS Cracks Down

by Renee Mielnicki, Esq.

An area of growing concern for employers is the misclassification of an employee as an independent contractor.  According to Internal Revenue Service (IRS) estimates, millions of workers are currently misclassified as independent contractors.  Misclassification allows employers to escape paying social security, medicare, unemployment and payroll taxes.  The IRS estimates that some employers save approximately $43,007 per year in taxes by misclassifying employees. Since the employer’s gain is the government’s loss, the IRS recently partnered with the Department of Labor (DOL) to share employment misclassification information. They set a goal of investigating 6,000 employers to increase tax revenue.  With a struggling economy and the government constantly on the brink of default, it’s no wonder this issue is a focus.

Another reason for targeting misclassification may be that employers with at least 50 employees will soon have to offer affordable health care under the Affordable Health Care Act or face penalties.  While misclassification may be even more tempting for employers in light of these new, costly requirements, the price if they get caught may not be worth it.

The tax and employee benefit savings may make it appealing for an employer to misclassify an employee as an independent contractor.  However, as scrutiny continues to rise, so do the consequences.  Currently, if you are audited by the IRS and found to have misclassified an employee, you will be forced to pay back taxes, with interest, and a penalty.  In addition, beginning in 2015, if a large employer (50 or more employees) fails to provide the minimum required level of affordable health care to an employee, an additional penalty of $2,000 per employee may apply.  Therefore, misclassification just got even more expensive for some employers beginning in 2015.

Additionally, Congress is now focusing on this issue.  Senator Bob Casey (D-PA) announced on November 12, 2013 that he recently introduced the “Payroll Fraud Prevention Act of 2013” bill at a hearing before the Senate Subcommittee on Employee and Workplace Safety.  If passed, the bill would make misclassification a federal labor offense and would impose additional monetary penalties.  Of bigger interest, the bill has a notice requirement that would obligate employers to inform both employees and independent contractors as to whether they have been classified as an “employee” or a “non-employee.”  If this bill passes, it would add one more dangerous repercussion in the misclassification arena.  Failure to simply provide the notice would result in a civil penalty of $1,100 for a first offense, and up to $5,000 for a second offense.  This is on top of the additional penalties that the bill would impose.

Employers are left to decide whether or not it’s worth it to misclassify an employee given all of these consequences.  Even if misclassification is unintentional, the penalties remain the same.  If an employer gets audited by the IRS, audits usually date back at least three years.  Some estimate that if an employer gets hit in an audit for misclassification, the penalty may be as much as 40% of the Form 1099 gross amount.  For small business owners, this may force them to close their doors. The best practice is then to first determine proper classification as an employee or an independent contractor.  The IRS considers three factors to help employers make this determination.  They are:

  1. BehavioralDoes the employer control, or have the right to control, what the worker does and how the worker completes his/her job?
  2. Financial.  Does the employer control the business aspects of the worker’s job?  For example, is the worker paid a salary?  Does the employer reimburse for expenses?  Does the employer provide the tools required for job completion?
  3. Type of Relationship.  Does the worker receive employee-type benefits?  Will the relationship continue after the work is finished?  Is the work a key aspect of the employer’s business?

While the IRS acknowledges that this is a complex issue, if the answer to most of these questions above is yes, chances are, the worker is an employee and not an independent contractor.

Employers who believe that they have misclassified workers as independent contractors may be able to correct the issue at a price much lower than a costly audit.  In 2011, the IRS announced its Voluntary Classification Settlement Program (VSCP) which allows certain employers to correctly reclassify independent contractors as employees.  In exchange for voluntarily reclassification of a worker as an employee, the employer pays a penalty of only 10% of the employer’s tax liability and will not be liable for any interest or penalties.   However, the employer has to agree to treat the worker as an employee in the future and pay the proper taxes.

In order to qualify for the program, the employer must pass three tests: (1) the employer must have consistently treated the worker an independent contractor; (2) the employer must have filed all required Form 1099s for the preceding calendar year; and (3) the employer must not currently be under audit by the IRS, DOL or any state government agency.

Before deciding to voluntary enter the VCSP program, employers should be aware of its potential downfalls.  Misclassification could expose the employer to wage and hour violation claims by a worker now classified as an employee which could impose further liabilities for benefit or compensation claims.  This is especially true in light of the IRS’s new partnership with the DOL to share misclassification information.

Then what should an employer do?  Employers should first analyze whether their current classifications are correct.  If they are not, before applying for the VSCP, the employer should weigh the potential costs of entering into the VCSP and the potential for exposure to other liabilities in litigation as compared to the costs of continued non-compliance and the potential of a future IRS audit.

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