By Stephen J. Dunn
Misclassification of employees as independent contractors for tax purposes is a widespread problem. Employers do it to avoid matching Social Security tax and Medicare tax on employees’ wages, effectively shifting those taxes to the employees in the form of self-employment tax. Misclassified employees are also excluded from participation in the employer’s benefit programs, such as health insurance and retirement plans.
Consequences of Classification
Where an employer treats a worker as an independent contractor, the employer withholds no taxes from amounts paid to the worker. For each calendar year, the employer must prepare a Form 1099 reporting the gross amount paid to the worker during the year, and send it to the IRS and a copy to the worker by the succeeding January 31.
Where an employer treats a worker as an employee, however, the employer must withhold income tax from the from the employee’s wages, as well as Social Security tax at 6.2% on the first $106,800 of gross wages earned during a calendar year, and Medicare tax at 1.45% of gross wages without limit. The employer must deposit the withheld income tax, Social Security tax, and Medicare tax, as well as a matching amount of Social Security tax and Medicare tax, with the IRS. The frequency of the deposits depends on the size of the employer. Large employers must deposit every few days. Each quarter the employer must prepare and file with the IRS Form 941, Employer’s Quarterly Tax Return. Form 941 summarizes gross wages, withheld income tax, Social Security tax, and Medicare tax, employer matching Social Security tax and Medicare tax, and the amounts and dates of deposits of such tax with the IRS. For each calendar year, the employer must prepare a Form W-2 reporting the employee’s gross pay, tax withholdings, and net pay. The employer must send the Forms W-2, with a Form W-3 summarizing them, to the IRS by the succeeding January 31. The employer must also mail each employee a copy of his Form W-2.
Who Is an Employee?
A worker is an employee if the person for whom he performs the services has “the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work, but also as to the details and means by which the result is accomplished.” Factors weighed in determining whether a worker is an employee include whether the worker undergoes training sponsored or specified by the person for whom the services are performed; whether the services are performed pursuant to instructions of person for whom services are performed, during hours set by the person for whom the services are performed, with tools provided by the person for whom the services are performed, on the premises of the person for whom the services are performed; whether the worker makes oral or written reports to the person for whom the services are performed; whether the worker is paid by the hour, week, or month; whether the worker makes an investment; whether the worker realizes a profit or loss; whether the worker hires, supervises, and discharges assistants; and whether the worker works for more than one firm at a time. No one factor is determinative.
VCSP No Help to Employers
The IRS’ recently-launched Voluntary Compliance Settlement Program (“VCSP”) purports to offer employers relief for voluntarily reclassifying their workers as employees. Employers should avoid the program, as the relief promised by it is illusory. Under the VCSP, an employer agrees to prospectively reclassify workers as employees for future tax periods. “In exchange,” the employer will pay 10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year.” The 10 percent applies not only to the employer matching Social Security tax and Medicare tax that would have been due on the workers’ wages, but also to the Social Security tax and Medicare tax which the employer would have been required to withhold from the workers and pay over to the IRS. The employer “will not be liable for any interest and penalties” on the additional tax liability, “and will not be subject to an employment tax audit with respect to the worker classification of the workers for prior years.” Finally, an employer participating in the VCSP program must agree to extend the statute of limitations on assessment of employment taxes from three years to six years three years for each of the three years following the year in which the employer enters the VCSP program.
Section 530(a)(1) of the Revenue Act of 1978 provides:
(A) for purposes of employment taxes, the taxpayer did not treat an individual as an employee for any period, and
(B) in the case of periods after December 31, 1978, all Federal tax returns (including information returns) required to be filed by the taxpayer with respect to such individual for such period are filed on a basis consistent with the taxpayer’s treatment of such individual as not being an employee,
then, for purposes of applying such taxes for such period with respect to the taxpayer, the individual shall be deemed not to be an employee unless the taxpayer had no reasonable basis for not treating such individual as an employee.
[Emphasis added.] There are two exceptions to application of Section 530 of the Revenue Act of 1978. The first is if the employer had no reasonable basis for treating the worker as an independent contractor for tax purposes. This is a very low standard for the employer to meet. The second is if the employer treated the worker as an employee for tax purposes for any period after 1978.
Where Section 530 of the Revenue Act of 1978 applies, reclassification of a worker from independent contractor to employee for tax purposes can only have prospective effect. There is no legal basis for assessing employment tax, penalties, or interest with respect to such worker for a prior period.
Why, then, would an employer voluntarily agree to pay any employment tax with respect to a worker classified as an independent contractor for a prior period for which the worker was classified as an independent contractor? Why, too, would the employer voluntarily agree to extend the assessment period for employment taxes with respect to such worker for each of the next three years?
As for an employment tax audit, the IRS is not all-knowing when it comes to employer classification of workers, and its resources are limited. In 33 years of practice, I can recall perhaps one employment tax audit, and it was not in recent years. Worker classification issues are raised if at all in an income tax audit of the employer. Such issues seldom are raised because the employer nearly always has a reasonable basis for treating a worker as an independent contractor.
Issuance of illusory pronouncements without a basis in law will not improve compliance with employment tax laws. Legislation requiring any person who hires another to withhold income tax, Social Security tax, and Medicare tax from the worker’s wages and pay it over to the IRS, along with employer matching Social Security tax and Medicare tax, would be much more effective. Federal revenues and the Social Security trust fund are far too important to depend on the fuzzy distinction between employee and independent contractor.