Worker Classification Issues

One of the most common areas of contention between the IRS and businesses is the issue of worker classification. If a worker is an employee, the business is responsible for payroll taxes and fringe benefits. However, if the worker is an independent contractor, the business is generally not responsible for payroll taxes.

The IRS estimates millions of workers are misclassified as independent contractors, depriving the federal government of huge sums of tax revenue. Consequently, the IRS is focusing on worker classification issues and has several audit initiatives in progress.

If a business incorrectly treats an independent contractor as an employee, the business will unnecessarily pay FICA and FUTA taxes and collect FIT withholding. However, if the business incorrectly treats an employee as an independent contractor, the business—

• may risk increased income and FICA taxes, penalties, and interest;
• may owe back FUTA taxes, with penalties and interest;
• may owe back pay and overtime under wage and hour laws;
• may jeopardize qualified benefit plans;
• may jeopardize other benefit plans;
• may be liable for the retroactive effect of reclassifying workers under state workers’ compensation and disability statutes, and state mandated benefits (such as parental leave or vacation time);
• may not be in compliance with other federal laws that only apply if the number of employees equals or exceeds certain thresholds (OSHA, ADA, FMLA, etc.); and
• may face other risks [for example, increased business liability for workers’ actions and liability for failing to obtain a Form I-9 (Employment Eligibility Verification) upon hiring the worker].

Classifying workers incorrectly can have significant consequences—from past due payroll taxes to fringe benefit plans. Thus, businesses should exercise due diligence when classifying workers as independent contractors.