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Employee or Independent Contractor? Classifying Workers Incorrectly Could Prove Costly

The Internal Revenue Service, in partnership with the U.S. Department of Labor and various state labor departments, continues to strongly enforce regulations meant to prevent misclassification of employees as independent contractors (ICs). Fortunately, an amnesty program is now in place that will allow an employer who has misclassified workers as ICs to bring them onto the employee payroll and avoid some of the federal penalties that would normally be incurred.

A crackdown on labor misclassification began in the middle of the last decade, partly because of the continually growing percentage of U.S. workers who were being hired as contractors instead of employees. Real and perceived abuses of led the IRS to hire a task force of another 100 agents earlier this year to investigate cases of worker misclassification. The estimated $25 million cost of stepping up enforcement is a drop in the bucket compared to the billions in formerly unpaid payroll taxes the government expects to bring in.

Businesses, of course, have many incentives – financial and otherwise – to hire some of their workforce as ICs instead of bringing them on as employees. Employers do not have to pay Social Security, Medicare or unemployment taxes on contractors, or offer them the same health insurance and other benefits that employees are eligible for. But the use of contractors also makes the workforce more flexible since hiring and firing them involves less paperwork and creates less risk of lawsuits based on alleged discrimination or other violations of labor laws. Payroll administration is simplified, too, because payments to ICs are simply reported on 1099 forms rather than going through the payroll processing system.

Needless to say, all of these advantages are lost – and then some – when the IRS makes a determination that a contractor actually fits the legal definition of an employee. Penalties and remedies for misclassification can include:

  • back payment of income taxes
  • back payment of payroll taxes (including what would normally have been the workers’ portion of Social Security taxes)
  • back pay to workers for unreimbursed overtime, sick leave or holidays
  • back payment of premiums to the company’s insurance provider
  • reimbursement to workers for medical expenses that the company’s insurance would have covered, had they been properly classified as employees

The Voluntary Classification Settlement Program (VCSP) announced by the IRS in September offers the possibility of greatly reduced federal back payments and penalties for qualifying employers who apply for the program, meet certain criteria and agree to certain stipulations. For example, businesses who want to voluntarily reclassify some of their ICs as employees must have filed all required 1099 forms for the last three years. They must also be willing to agree to leave the next three years’ taxes open to IRS audit for 6 years instead of the usual 3 years.

It’s important to remember that the VCSP is a federal program. Many states have enacted their own legislation on this issue in recent years, and the VCSP does not deflect any penalties or sanctions at the state level. California’s new misclassification law is particularly harsh, raising the maximum state fine for misclassifying a worker from $5,000 to $25,000.

Even small business payroll can be complicated, but it’s a lot simpler when you hire the experts at Padgett Payroll Services. Call (706) 548-1040 today to find out more about the benefits of letting us take care of your company’s payroll management.

We encourage you to contact us with any questions.

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