Worker Misclassification

Worker misclassification is a critical issue that occurs when an employer incorrectly classifies a worker as an independent contractor rather than an employee. In practical terms, this means the employer issues the worker a Form 1099/Form 1099-NEC instead of a Form W-2. Such misclassification can result in severe consequences for employers, impacting both the business and its workers.

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The Importance of Proper Classification

For tax purposes, worker classification has far-reaching implications. It affects how and when taxpayers pay Federal Income Tax, Social Security, and Medicare Tax. It also determines how they file their tax returns, what forms they use, their eligibility for Social Security and Medicare benefits, and employer-provided benefits.

Employers have specific responsibilities when it comes to employees. They must accurately calculate and withhold Federal Insurance Contributions Act (FICA) taxes from employees’ wages. Furthermore, employers are responsible for paying social security, Medicare, and Annual Federal Unemployment Tax (FUTA) on their employees’ wages.

In contrast, when a worker is issued a Form 1099/Form 1099-NEC from an employer and earns over $400 in net earnings, they generally must pay self-employment tax. This self-employment tax includes Social Security and Medicare taxes, similar to those withheld from most wage earners’ pay.

Beyond tax implications, misclassification has serious labor-related consequences. Misclassified employees may be deprived of important labor protections and benefits, such as overtime pay and unemployment insurance.

Consequences of Misclassification

The repercussions of worker misclassification can be severe, varying based on whether the misclassification was unintentional or intentional/fraudulent, as outlined below.

Unintentional Misclassification of Workers:

icon$50 penalty for each W-2 the employer failed to file
iconPenalties totaling 1.5% of the wages for failure to withhold income taxes
icon40% of the FICA taxes not withheld from the employee
icon100% of the matching FICA taxes the employer should have paid
iconA failure-to-pay penalty equal to 0.5% of the unpaid tax liability for each month (up to 25%)
iconAny applicable interest

Intentional or Fraudulent Misclassification of Workers:

iconUp to one year in prison for the employer
iconPersonal liability for the person responsible for withholding taxes for any uncollected tax under IRC 6672
icon$50 penalty for each W-2 the employer failed to file
iconPenalties totaling 1.5% to 3% of the wages for failure to withhold income taxes
icon40% of the FICA taxes not withheld from the employee
icon100% of the matching FICA taxes the employer should have paid
iconA failure-to-pay penalty equal to 0.5% of the unpaid tax liability for each month (up to 25%)
iconAny applicable interest
iconAdditional fines or penalties from the IRS and Department of Labor ranging from $10,000 to $25,000 per employee

Avoiding Misclassification Issues

To determine whether a worker is an independent contractor or an employee for federal employment tax purposes, the IRS follows common law rules. These rules consider several factors that fall into three main categories: behavioral control, financial control, and the relationship of the parties.

Behavioral Control: This category examines whether the business has the right to direct and control what work is accomplished and how the work is done through instructions, training, or other means. If so, the worker is more likely to be an employee. Key questions include:

  • Does the business control what tools or equipment the worker uses?
  • Does the business control what assistants the worker hires?
  • Does the business control where the worker purchases supplies and services?

Financial Control: This aspect looks at whether the business has a right to direct or control the financial and business aspects of the worker’s job. Factors to evaluate include:

  • The extent of the worker’s unreimbursed business expenses
  • The extent of the worker’s investment in facilities or tools used in performing services
  • The extent to which the worker makes their services available to the relevant market
  • How the business pays the worker
  • The extent to which the worker can realize a profit or incur a loss

Relationship of the Parties: This category examines the type of relationship between the worker and the business. Consider the following:

  • Does the worker receive employee-type benefits, such as insurance, pension, vacation pay, or sick pay?
  • Are there written contracts or oral agreements describing the relationship the parties intended to create?
  • What is the permanency of the relationship?
  • To what extent are the services performed by the worker a key aspect of the regular business of the company?

IRS Processes to Resolve Employee Versus Independent Contractor Disputes Form SS-8: Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, can be used by workers to request a determination from the IRS regarding a worker’s tax status.

Filing Form SS-8 provides workers with an opportunity to obtain an official determination from the IRS regarding their tax status. This clarity can help workers understand their rights and responsibilities under the law. During the SS-8 process, if certain requirements are met, workers must also file IRS Form 8919, Uncollected Social Security and Medicare Tax on Wages, to figure and report their share of uncollected Social Security and Medicare taxes due on their compensation.

Voluntary Classification Settlement Program (VCSP)

The VCSP is a voluntary program administered by the Internal Revenue Service (IRS) that allows eligible employers to voluntarily reclassify their workers as employees for federal employment tax purposes. By participating in the VCSP, employers can proactively address potential worker classification issues and reduce their exposure to penalties and other consequences associated with misclassification. Want to learn more about the VCSP? Be sure to read more on our dedicated VCSP page.

Navigating Worker Misclassification

Businesses should carefully evaluate the nature of their relationships and the level of control they have over their workers to avoid misclassification issues. At Azarvand Tax Law, we understand the complexities and risks associated with worker misclassification. Our team of experienced tax attorneys is dedicated to helping taxpayers navigate these challenges with confidence.

Contact us at Info@AzarvandTaxLaw.com or visit our Contact Us page to schedule a free 30-minute consultation and take the first step towards protecting your interests and ensuring compliance with tax laws and regulations.