The IRS maintains its own test for classifying independent contractors. Misclassification may result in expensive penalties to the employer.
Independent contractor rules have been the source of a fair amount of media coverage during 2020 and 2021. During the Trump administration, the United States Department of Labor (“DOL”) proposed an update to the rule governing the classification of independent contractors. However, shortly after the Biden administration took office, the DOL issued a notice to withdraw the proposed rule. As a result, on May 6, 2021, the proposed independent contractor rule was officially withdrawn and the DOL will continue to use the more traditional “economic realities” test applied by courts.
Misclassification of Independent Contractors Under IRS Rules
Despite the changing landscape in the DOL, the Internal Revenue Service (“IRS”) has maintained steady rules regarding the classification of independent contractors. Failing to properly classify an individual as an independent contractor may result in expensive penalties to the employer. 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 up to 3% of the wages, plus up to 40% of the FICA taxes that were not withheld from the employee and up to 100% of the matching FICA taxes the employer should have paid. If the IRS determines that an employer misclassified its employees willfully, the penalties are even greater. 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.
Employers should exercise caution and seek legal counsel in categorizing 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.
This is an update to the article, IRS Misclassifications and Costly Penalties: Independent Contractor or Employee?