The IRS has significantly increased their employment tax enforcement efforts and just released a Fact Sheet (FS-2015-21) explaining how employers can properly determine whether workers should be classified as employees or independent contractors. A wrong decision can result in potentially significant civil penalties or in the event of an intentional mis-classification, those involved might be subjected to the criminal prosecution.
Employers generally must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to employees. Employers generally don’t have to withhold or pay any taxes on payments to independent contractors. Before determining how to treat payments for services, employers must determine whether individuals providing the services are employees or independent contractors. IRS Fact Sheet 2015-21 provides information on making that determination and what to do about misclassified workers.
Determining Whether the Individuals Providing Services are Employees or Independent Contractors. Under pressure from Congress, the Internal Revenue Service (IRS) has been aggressively attempting to reduce the tax gap – the annual shortfall between taxes owed and taxes paid. In the past, employment taxes has been identified by IRS and other federal agencies as contributing $54 billion to the approximate $290 billion tax gap. Accordingly, the classification of workers as either employees or independent contractors is gaining attention.
Past studies by the IRS revealed that millions of workers were being misclassified as independent contractors, and the IRS estimates that employers who misclassify employees as independent contractors are costing the government billions of dollars a year in lost income taxes. Most often, the problem is not intentional misclassification, but uncertainty about how to classify workers.
Whether a worker is deemed an independent contractor or employee is fundamental to the Internal Revenue Code. It has been said that roughly 60 percent, or more, of all federal tax revenue comes through the employment tax system. When taxes are withheld from an employee, compliance rates are generally at their highest. Compliance rates are reduced (even when Forms 1099 are filed) where no withholding is required.
For federal tax purposes, there are only two job classifications in the American workplace. A worker is either an employee of the service-recipient or an independent contractor (i.e., self-employed) – and either worker classification can be a valid and appropriate business choice. The distinction between independent contractors and employees arose at common law to limit a service-recipient’s vicarious liability for the misconduct of the person rendering the service. The extent to which the service-recipient had a right to control the details of the service activities was highly relevant to the question of whether the service-recipient ought to be legally liable for those activities.
For Federal tax purposes a worker is classified as either an employee or an independent contractor in one of three ways:
(1) Common Law Factors. In general, the common law relationship of employer and employee exists if the person for whom the services are performed has the right to control and direct the worker who performs the service, not only as to the result to be accomplished, but also as to the details and means by which the result is accomplished. Rev. Rul. 87-41 sets forth twenty common law factors or elements that are relevant in determining whether the relationship of employer and employee exists, but no clear test is provided. More recently, the IRS has identified three categories of evidence that may be relevant in determining whether the requisite control exists under the common-law test and has grouped illustrative factors under three categories: (1) Behavioral control; (2) Financial control; and (3) Relationship of the parties. The IRS emphasized that factors in addition to the 20 factors identified in 1987 may be relevant, that the weight of the factors may vary based on the circumstances, that relevant factors may change over time, and that all facts must be examined.
(2) Statutory Employees and Non-Employees. Certain workers are classified as employees or non-employees by statute. For example, pursuant to Internal Revenue Code Section 3401(c), for income tax withholding purposes the term “employee” includes an officer of a corporation.
(3) “Safe Harbor” Independent Contractors. Congress has created a “safe harbor” within which a worker is treated as an independent contractor if the service-recipient meets specific requirements and has a “reasonable basis” for not treating the worker as an employee.
California Employment Taxes and the EDD. In California, the Employment Development Department (EDD), like the IRS, generally applies a common law test to determine whether a worker is an employee or an independent contractor. In addition, some workers are considered statutory employees or non-employees for certain purposes. There is, however, no California “safe harbor” for treating a worker as an independent contractor.
Increased IRS Focus. Taxpayers can expect increased IRS focus in the area of employment tax enforcement. Following the three year National Research Program (NRP) to study the statistically valid information for computing the Employment Tax Gap and to determine compliance characteristics, the IRS can now focus on the most noncompliant employment tax areas. Legislative changes may also be on the horizon to combat perceived historic non-compliance and to offer clearer guidance in the area, that in effect has been on hold for more than 30 years after passage of the Section 530 of the Revenue Act of 1970. Non-tax reasons also exist for increased Government attention. Employees who are misclassified as independent contractors may not have access to certain employer-provided benefits, such as health insurance coverage and pension plans.
Section 530 Employment Tax Relief. According to the Fact Sheet, if a business classifies an employee as an independent contractor and they have no reasonable basis for doing so, they may be held liable for employment taxes for that worker and certain relief provisions will not apply. If a business has a reasonable basis for not treating a worker as an employee, they may be relieved from having to pay employment taxes for that worker. See Publication 1976, Section 530 Employment Tax Relief Requirements (PDF) for more information.
Voluntary Classification Settlement Program (VCSP). To the Government’s credit, the IRS allows for a fair and appropriate mechanism to correct past non-compliance in this area. The Voluntary Classification Settlement Program (VCSP) is an optional program that provides taxpayers with an opportunity to reclassify their workers as employees for future tax periods for employment tax purposes with partial relief from federal employment taxes for eligible taxpayers that agree to prospectively treat their workers (or a class or group of workers) as employees. To participate in this voluntary program, the taxpayer must meet certain eligibility requirements, apply to participate in the VCSP by filing Form 8952, Application for Voluntary Classification Settlement Program, and enter into a closing agreement with the IRS.
Conclusion. The proper classification of workers can be a difficult task for businesses and the IRS alike. One thing is for certain, however, in this current environment the public should expect increased IRS enforcement if workers have been improperly classified as independent contractors rather than employees.
MICHEL R. STEIN – For more information please contact Michel Stein – Stein@taxlitigator.com Mr. Stein is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Mr. Stein has significant experience in matters involving federal and state worker classification issues and in matters involving previously undeclared interests in foreign financial accounts and assets, the IRS Offshore Voluntary Compliance Program (OVDP) and the IRS Streamlined Filing Compliance Procedures. Additional information is available at www.taxlitigator.com