Jul 28, 2021How the IRS Handles Employee Misclassifications

What happens when a business pays a W-2 employee as an independent contractor? Often times classification mistakes are made during the initial hiring process that cause individuals who should be designated as employees to actually be designated as contractors. This article will discuss the consequences of a business misclassifying an employee, how the IRS treats this scenario, how to remedy the situation, and how to prevent it from happening again.


The Consequences

Before delving into the consequences of misclassification, it is important to know why a misclassification is such a serious infraction. Generally speaking, classifying individuals as contractors rather than employees can save a company a lot of money in benefits, overtime pay, unemployment, FICA taxes, and more. The IRS does not want companies getting away with this because it reduces government revenue and hurts working individuals.

So what are the penalties for misclassification? The severity of the penalty depends on whether or not the company unintentionally or intentionally misclassified the individuals. If the misclassification was unintentional, the employer faces at least the following penalties, based on the idea that all previous payments to contractors must be reclassified to employee wages:

  • $50 penalty for each Form W-2 that the employer failed to file (because a 1099 was filed instead)
  • Because the employer failed to withhold income taxes and FICA taxes, the penalty is equal to 1.5% of the wages plus 40% of the FICA taxes that were not withheld from the employee
  • 100% of the matching FICA taxes the employer should have paid if the individual was correctly classified as an employee
  • A “Failure to Pay Taxes” penalty equal to 0.5% of the unpaid tax liability for each month unpaid (up to 25% of the total tax liability)
  • Interest charges on amount of employer’s outstanding tax liability

Fraud or intentional misclassification can increase these penalties substantially. Because of the severe risk of liability in either scenario, it is important for employers to understand the conditions or actions that must be met to mitigate penalties.


IRS Treatment

The IRS obviously views the misclassification of employees as independent contractors as a very serious issue. The penalties described above would prove to be very costly to any employer. Essentially, the IRS treats misclassification scenarios as though there is a large outstanding amount of tax due. The situation is very similar to taking an aggressive or risky position on a tax return. It is typically done to save money up front but may come back to haunt you later.

The IRS has provided a safe harbor provision under section 530 that completely eliminates the back employment taxes and penalties described above. In order qualify for section 530 relief, the employer must meet the following three conditions:

  • Reporting Consistency – The employer must have timely filed all required federal tax returns consistent with the treatment of each worker as not being an employee.
  • Substantive Consistency – The employer must have treated the workers, and any similar workers, as independent contractors. If an employer treats similar workers as employees this provision does not apply.
  • Reasonable Basis – The employer must show that they have reasonable basis for the classification. Reasonable bases may include reliance on federal court cases, previous IRS audits, or industry standards.


How to Remedy & Prevent

Many companies and employers often realized that they have been misclassifying employees as independent contractors after the fact. This raises a couple of interesting questions. How should companies best (and most affordably) remedy the situation? How can employers prevent the situation from happening again?

Employers generally have three options to remedy the misclassification of employees. As is typical in tax law, the use of each option depends heavily on an employer’s situation. The three options are as follows:

  • Advance Determination of Worker Status – In order to apply for this program, an employer must fill out Form SS-8. This form can be used only if the employer is not under audit. Under this program, tax liability can be reduced to one year.
  • Classification Settlement Program – This program is only for employers currently under audit by the IRS that don’t meet the safe harbor under section 530. If an employer does not meet either the reporting consistency or reasonable basis test, they may still be eligible to apply for CSP relief. Under this program, tax liability can usually be reduced to one year.
  • Voluntary Classification Settlement Program – This program can be the most advantageous for eligible employers. In order to be eligible, employers must not have been under audit for the past three years. The penalty under this program is reduced to only 10% of the employment tax liability due on compensation paid to workers in the most recent tax year. Penalties for worker classification in prior years are forgiven under this program.

After remedying any misclassification issues, employers have the option to fill out and submit a Form SS-8. This form basically asks the IRS to make a determination for the employer as to the status of a potential employee or contractor. Although not convenient, this process will certainly protect employers and companies for future potential employment tax liability.

The classification of employee vs. independent contractor is an important and complex one. As described, the penalties and taxes involved with misclassification can be severe. Companies should strongly consider seeking professional advice in this area.