There has been a renewed interest in the distinction between employees and independent contractors. This can largely be attributed to the implementation of various aspects of the Affordable Care Act, as many of the provisions associated with the law relate to the number of employees working at a company.
This has become such a hot topic that the Department of Labor (DOL) allocated nearly $10 million of its 2016 fiscal year budget solely to the investigation of misclassified workers.
In previous posts, we have discussed the differences between employees and independent contractors, as well as what actions employers should take if there is a need to re-classify. In this post, we’ll outline the penalties that can be levied by the DOL if a worker is misclassified.
If a business misclassifies, the employer may be subject to taxes, fines and penalties associated with the following areas:
1. Federal income tax: The employer is subject to tax for failing to withhold federal income tax of 1.5 percent of the wages paid. If the employer also fails to file the appropriate forms (information returns, namely Form 1099) to the IRS, the tax could double. Additionally, the employer could also be subject to penalties and interest charges for failure to file the appropriate payroll forms and failure to pay the tax.
2. FICA: Employers and employees are taxed on the Federal Insurance Contributions Act (FICA), which is used to fund Social Security and Medicare. If an employer fails to withhold the employee’s side of the tax contribution, the employer is subject to a tax of 20 percent of the employee's share of the tax in addition to the employer's share. If the employer fails to file the appropriate forms (information returns, namely Form 1099) with the IRS, or worse, if the IRS deems the misclassification intentional, the tax doubles to 40 percent. Additionally, the employer could also be subject to penalties and interest charges for failure to file the appropriate payroll forms and failure to pay the tax.
3. Unemployment tax: Penalties related to the unemployment tax may also apply, though it depends on the jurisdiction in which the company is governed. Because states operate by different regulations, penalties may differ from state to state and are issued on a case by case basis. For example, if you were dealing with a worker misclassification in Tennessee they would likely assess State Unemployment Tax Act (SUTA) taxes for the period of time a worker was misclassified as an independent contractor rather than an employee. In this situation, the employer would be responsible for the SUTA, which is limited to 2.7 percent of the first $9,000 in wages. Additionally, the state would likely charge interest (approximately 1.5 percent) in the unpaid SUTA.
4. Payroll tax: The IRS takes payroll taxes very seriously. If a business fails to pay the appropriate amount of payroll taxes, the IRS has the right to hold the business owner or chief executive of the company personally liable for the missing payments, which could result in penalties.
Additionally, and this applies to all of the tax areas mentioned above, if delinquent taxes enter the “collections state,” the IRS can file liens against the business. If this happens, it could create even more trouble for the employer. However, this usually only happens in extreme circumstances, usually when the tax-paying party is non-compliant. The longer the problems go on, the worse the situation could become.
Given the renewed focus on this area, businesses need to be especially cautious when deciding how to classify their workers and should carefully consider the independent contractor parameters before making a final decision. Additionally, if employers need to re-classify, it is imperative that they do so as soon as possible using the Voluntary Classification Settlement Program (VCS Program). Regardless of the classification made, businesses should clearly document their determination by retaining contracts, invoices and any other evidence that could back up their conclusion.
Lastly, in order to avoid penalties and fines, employers need to stay informed and abreast of any changes in the tax code. However, considering the nuances and complications associated with this section of the Internal Revenue Code, the best action employers can take to avoid penalties is to consult with a professional.