Burr & Forman

07.17.2019   |   Articles / Publications

IRS Misclassifications and Costly Penalties: Independent Contractor or Employee?

Failing to properly classify an individual as an independent contractor can result in expensive penalties to the employer – imposed by both the United States Department of Labor and the Internal Revenue Service. As it pertains to the IRS, if an employer-employee relationship exists, the earnings of the employee are subject to FICA (Social Security and Medicare) and income tax withholding. If the IRS determines that an individual has been misclassified it may levy penalties against the employer, including, but not limited to, a $50 fine for each Form W-2 the employer failed to file on such employee, a penalty of 1.5% of the wages, plus 40% of the FICA taxes that were not withheld from the employee and 100% of the matching FICA taxes the employer should have paid. These penalties can be costly and, in some cases, devastating for an employer.

While the test for determining employee status is well-established under the Fair Labor Standards Act, the IRS utilizes its own test and factors in evaluating the employee relationship which evaluates the degree of control and the degree of independence exercised by the individual in the performance of his duties. The IRS balances three factors in making this determination: behavioral, financial, and relational details. The behavioral factor explores whether the employer has the right to control the work performed by the worker. The financial factor asks who supplies the tools and supplies needed by the worker, how the worker is paid and whether the worker is free to offer services to others in the relevant market. Finally, the relational factors examine whether the worker has a written contract or benefits provided by the employer. Taken together, these factors determine employee status for purposes of an employer’s obligations for employment taxes accrued for a worker.

The issue of misclassification appears to be a topic of interest for the IRS in recent months. Employers should exercise caution and seek legal counsel in categorizing the employees versus independent contractors in their workforce. The IRS allows employers to file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, to seek a conclusion as to whether a worker is an employee or independent contractor.

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