What You Should Know About Worker MisclassificationSince the downturn in the economy, businesses have been looking for ways to cut costs, and the largest cost for many is payroll. Companies might engage more part-time and temporary workers, in addition to independent consultants, to reduce expenses. However, business owners could find themselves in a difficult position if they don’t know the rules of how to classify these workers.
Due to tight budgets and decreased collections, federal and state governments are also cutting costs and looking to generate additional revenue. These governments have focused efforts on misclassification of workers to collect unpaid employment taxes. A similar push by the IRS from 1988 through 1994 reclassified 483,000 workers as employees and resulted in $751 million in assessments.
Business owners trying to reduce costs would rather have their workers classified as independent contractors than as employees. Employers are required to withhold and submit federal and state withholding taxes from an employee’s payroll, and pay Social Security, Medicare, and unemployment taxes on their behalf. Depending on how the company’s plans are set up, they could also provide health, dental, retirement, and other benefits to everyone classified as an employee. Sick time and vacation time might also be paid. State protections such as wage-and-hour laws may apply only to employees, and employment arrangements can be much more difficult to terminate.
Independent contractors are considered self-employed individuals. Some workers appreciate the flexibility and the ability to deduct additional un-reimbursed expenses against income. The contractor is responsible for paying the employer and employee contributions for Medicare and Social Security taxes, and they receive a deduction on their tax return for the employer portion. They are expected to make quarterly estimated tax payments on their income since they are not having taxes withheld. Health and other insurance is the self-employed individual’s responsibility, and they may be entitled to a deduction for tax purposes. The company using their services is responsible for acquiring the appropriate federal identification number and issuing a form 1099 at the end of the year if they paid the worker over $600, but they do not incur payroll-tax liabilities.
Issues with classification are generally noted when a worker applies for unemployment, since employees are eligible, while self-employed individuals are not. Effective in 2008, the federal government implemented the Emergency Unemployment Compensation Program, which provides federal funding to extend unemployment benefits up to 53 weeks. An additional program effective in 2012, the Federal-State Extended Benefits Program, provides for an additional 20 weeks of unemployment during periods of high unemployment on a state-by-state basis.
Therefore, depending on the employee’s state, the individual may be eligible for up to 99 weeks of payments. The more attractive the unemployment benefits become, the more likely individuals are to apply and open up the inquiry into whether they were previously employed.
Determining whether a worker is an employee or an independent contractor is more complex than simply how the worker is paid or whether they work full-time or part-time. The IRS has historically used a series of questions referred to as the ‘20-factor test’ to establish worker status. The 20-factor test was not intended to be used as a pass-or-fail determination. However, the results were often unclear because some of the questions did not affect the final result of the test.
In a 2009 update to its manual for auditors, the IRS noted that some of these questions could be inapplicable, other pieces of information could be pertinent, and relevancy changes over time given the circumstances. Therefore, it revised its approach to include more general considerations organized into three categories: behavioral control, financial control, and relationship of the parties.
Behavioral control exists when the employer directs the employee in the way that they perform their duties. The level of instruction and training the worker receives, who provides the tools or equipment, and when and where the work should be done would all be factors to consider in this area. The business can, of course, indicate the result of the work to be performed, but when it also has control over the means and methods to achieve the result, it is acting more like an employer.
Financial control includes considerations related to whether the worker acts like a self-employed person. For example, to what extent do they make themselves available to assist multiple businesses? An independent contractor might also have made their own financial investment in facilities, tools, or equipment; might incur unreimbursed expenses related to their work; and could achieve a profit or a loss. To establish the relationship between the business and the worker, the IRS would look at the permanency of the relationship as well as to what extent the work performed is an integral part of the company’s business.
A written contract would be a consideration in determining the relationship of the parties, but it cannot be used to avoid classification as an employee if other factors indicate that relationship.
Many states, including Massachusetts and Connecticut, have moved away from the IRS definition of ‘employee,’ and have adopted another test for determining worker status. In addition, some states have separate tests for unemployment and workers’ compensation classifications. Often, specific industries, such as construction contractors, have stricter rules.
The most common non-IRS test is called the ‘A, B, C’ test. This test has three factors, all of which must be met for the worker to be considered an independent contractor. The first test is whether the employer exercised control and direction over the worker. This is similar to the behavioral-control test. The second test asks whether the duties performed were outside of the usual course or all normal places of business; integral functions of a business generally would be performed by employees. The final test is the most stringent, and is where this type of test differs from the IRS. A contractor must be engaged in an independently established trade or business. To meet this definition, it could be shown that the worker has his or her own business license, insurance, or federal identification number.
Penalties for misclassification of workers differ depending on whether the misclassification is considered an intentional disregard for the requirements. If it is deemed intentional, the employer is responsible for all back taxes. If no intentional disregard is found, the employer can use Section 3509 rates to calculate their federal liability. The rates are lower if the employer issued the appropriate 1099 forms.
If the forms were filed, the employer is liable for the employer’s share of Social Security and Medicare plus 20% of the employee’s portion. In addition, the employer is responsible for income tax at a rate of 1.5% of wages. If the 1099s were not filed, the amounts increase to 40% of the employee’s portion of Social Security and Medicare and 3% income taxes. The employer owes even if the worker properly paid income taxes and self-employment taxes on their income, and cannot recover amounts from the employee. The business would be responsible for unpaid benefits such as retirement-plan contributions for the reclassified employees. On top of the federal requirements, the employer will likely have state tax liabilities and may face steep fines and penalties.
A business can be absolutely certain that the IRS will agree with its worker classification only by obtaining a determination letter directly from the source. Form SS-8 is organized with questions in the three factor categories and provides information the IRS can use in issuing the determination. The form can be filed with the IRS by a firm or by a worker to receive a resolution for purposes of federal withholding and employment taxes only, although many states that conform to IRS rules will accept the determination. States that do not conform to IRS rules generally also have a request form to file with their employment divisions.
The IRS and many states have voluntary settlement programs whereby a company is required to file and pay only for the last few years, but these programs are available only if no notices or inquiries have been received. If you are unsure whether your workers are properly classified, it is best to speak with your accountant or labor attorney as soon as possible to gauge your exposure.
Charlotte Cathro is a tax manager for the Holyoke-based public accounting firm Meyers Brothers Kalicka, P.C.; [email protected]