Earlier this year, the Obama Administration indicated it would make a concerted policy effort to focus on companies that misclassify employees as independent contractors. In addition, the IRS has announced plans to audit 6,000 companies for employment tax compliance over the next three years. Due to the ambiguous legal framework within which worker relationships are defined for federal tax purposes, and the increasing importance of revenue collection by the IRS in the face of a mounting federal deficit, businesses that do not have clearly delineated worker arrangements may find themselves facing a large assessment.
For most businesses, the choice to treat one or more workers as independent contractors is a business decision. However, businesses should be sure to adequately analyze whether the choice to treat a particular worker as an independent contractor is consistent with the actual worker relationship. Subject to exceptions for certain statutory employees, the IRS generally analyzes twenty factors to determine whether a worker is an employee or independent contractor. In sum, these factors examine the following core principles: (1) the degree of control exercised by the principal; (2) whether the principal or the worker invests in equipment, facilities, tools and materials; (3) whether the worker has the opportunity to realize a profit or loss; (4) whether the worker provides services to more than one business (or holds himself or herself out as doing so); (5) whether the worker is part of the principal’s regular business; (6) the permanency of the working relationship; (7) whether the worker is treated similarly to the principal’s employees (for example, being paid a salary, participating in employee benefits, etc.) and (8) the intent of the parties when entering into the working relationship.
The classification of some worker relationships is obvious. The administrative assistant who works forty hours each week for the company’s vice president is likely an employee. The assistant is subject to the control of the vice president for whom he or she works, is provided with all necessary tools and supplies, works on a full-time basis for one company, is paid a salary or hourly wage and is treated similarly to other staff members. On the other hand, a painter hired by a company to paint the inside of the company’s office building is likely an independent contractor. The company exerts little control over the painter’s work, does not provide any tools or supplies, intends the relationship to be temporary (until the job is completed) and the painter will realize either a profit or loss on the project.
Those businesses, however, who have worker relationships where some factors indicate an employment relationship, but who choose to treat workers as independent contractors, are the type of businesses most likely at risk of a tax assessment if audited. These types of worker relationships often arise in the context of data entry workers, transcriptionists, sales agents, software developers, workers hired on a project basis, workers hired in the entertainment and advertising industries (performers, photographers, etc.) and even professionals such as accountants, physicians and lawyers. In addition, some workers may be dually classified – acting as both an employee and an independent contactor for the same business. Such dually classified working relationships must be carefully analyzed to ensure that the worker is acting in two separate and distinct capacities. In all cases in which an independent contractor is utilized to carry out the company’s business, the working relationship must be vigilantly structured and the contract between the company and the worker must be drafted to reflect a clear independent contractor relationship.
The tax consequences of misclassifying workers are severe. An employer is required to withhold income taxes and the employee’s share of FICA taxes and must also pay over its share of FICA taxes and the FUTA tax. If workers are misclassified, the employer may be on the hook for the withholding failures as well as the failure to pay its part of FICA and FUTA, plus interest and applicable penalties.
If the employer can show that it did not intentionally disregard the requirement to deduct and withhold taxes, the employer’s liability for employee witholdings is limited pursuant to the prescribed tax rates under Code Section 3509; namely, 1.5 percent of wages for income tax withholding (or 3 percent if no 1099s were filed) and 20 percent of the employee FICA not withheld (or 40 percent if no 1099s were filed). However, the recent Obama Administration Budget proposes to limit the applicability of the prescribed liability limits under Section 3509 to only those employers who voluntarily reclassify workers, not where reclassification occurs through an IRS audit. In all cases, the employer is on the hook for the full amount of the employer’s share of FICA and FUTA. Other consequences of misclassifying workers may include liability for State taxes, liability for non-payment of workers’ compensation insurance, unlawful discrimination from welfare benefit plans and qualified pension plans and a host of other employment related legal violations.
In addition, in cases where the IRS perceives that the business under audit has attempted to disregard the law, corporate officers and certain employees may be personally at risk. Code Section 6672 imposes a trust fund penalty on “responsible persons” who willfully fail to collect, account for and pay over to the government any tax the business is required to withhold and pay over. The penalty is 100% of the tax required to have been withheld and paid over. In many cases, the IRS will assess the 100% penalty against each and every officer of the company (even though the IRS can only collect the tax once). Therefore, if the IRS takes the position that the worker misclassification is willful, it may invoke Section 6672 to impose personal liability on several responsible persons.
A responsible person is any person who had the effective power to cause the company to properly withhold and pay over the applicable taxes. To act “willfully” means that the responsible person acted or failed to act in a conscious and voluntary manner, with knowledge or intent that the appropriate taxes would not be withheld and paid over. Turning a blind eye will not relieve a responsible person from trust fund penalties. In a case decided this year, a district court in North Carolina found that a company’s President acted willfully where the President failed to confirm and investigate whether the company was meeting its payroll tax obligations when he knew the company was having cash flow problems. Last year, the Court of Appeals for the 5th Circuit found that the chairman of the board of a tax-exempt hospital acted willfully where he did not inquire and investigate as to the hospital’s payment of payroll taxes when he knew the hospital was facing financial hardship.
If the IRS ultimately challenges worker classification, some businesses may qualify for Section 530 relief. Where available, Section 530 relief precludes the IRS from assessing liability for income tax withholding, FICA and FUTA. To qualify for Section 530 relief, the employer must establish that it classified all workers holding substantially similar positions in the same manner and also consistently filed information returns (Forms 1099). In addition, the employer must show that it had a reasonable basis for treating the worker as an independent contractor (for example, judicial precedent). We understand that the Obama Administration has proposed repeal of Section 530. This bears noting particularly for those businesses with workers whose classification as an employee or independent contractor is uncertain.
Other changes proposed by the Obama Administration include requiring businesses to notify independent contractors of their status and explain the implications of the classification and giving contractors the option to require the principal to withhold federal tax at a flat rate selected by the contractor (to remedy the perceived underreporting of income by Form 1099 recipients).
With the federal deficit increasing and the Obama Administration honing in on misclassified workers, businesses with independent contractor arrangements should review these arrangements, including the contracts that are in force, to assess potential deficiencies in payments of FICA, FUTA and applicable withholdings, and to take appropriate remedial action.