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Employees Vs. Independent Contractors

(posted: December 6th, 2017)


Worker classification remains a priority, and is frequently applied incorrectly.

The Internal Revenue Service continues to seek back taxes and penalties from firms that wrongly treat workers as contractors.

Unreported or under-reported employment taxes make up a big chunk of the overall federal tax gap. The Labor and Justice departments and the states also have vital roles to play in ensuring that workers are properly classified by the businesses they work for.

The stakes have always been high: lost taxes for federal and state governments and fewer benefits for workers who are improperly treated as contractors. Their importance is magnified with the growth in freelance service gigs, much of it through the sharing economy with Uber, Rover, Grubhub and the like.

To classify workers, the IRS uses three tests, each made up of multiple factors:

  1. The behavioral test focuses on whether the company controls or has the right to control what the worker does and how to do the job. Key factors for employee status include instructions about performing the work, evaluation criteria and training.
  2. The financial test looks at who controls the economics of the worker's job. Being able to work for multiple firms and providing your own tools needed for the job are indicative of independent contractor status. Some factors favoring employee status are eligibility for reimbursement of travel costs and payment based on hours worked.
  3. The type-of-relationship test examines how the parties perceive each other. Providing paid vacation and retirement benefits indicates a worker is an employee, as does hiring to provide services indefinitely rather than for a specific time period. Written language stating the worker is an independent contractor isn't determinative.

What Are the Penalties?

The ramifications for an employer can vary depending on whether or not the DOL and the IRS determine the misclassification was unintentional or intentional, or even fraudulent.

If it was unintentional, the employer faces at least the following penalties based on the fact that all payments to misclassified independent contractors have been reclassed as wages:

  • $50 for each Form W-2 that the employer failed to file because of classifying workers as an independent contractor.
  • Penalties of 1.5% of the wages, plus 40% of the FICA taxes (social security and Medicare) that were not withheld from the employee and 100% of the matching FICA taxes the employer should have paid. Interest is also accrued on these penalties daily from the date they should have been deposited.
  • A "Failure to Pay Taxes" penalty equal to 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability.

If the IRS suspects fraud or intentional misconduct, it can impose additional fines and penalties. For instance, the employer could be subjected to penalties that include 20% of all of the wages paid, plus 100% of the FICA taxes, both the employee's and employer's share. Criminal penalties of up to $1,000 per misclassified worker and 1 year in prison can be imposed as well. In addition, the person responsible for withholding taxes could also be held personally liable for any uncollected tax.

Clearly, it would be wise to get your employees properly designated as either contractors or employees!

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