IRS Penalties for Misclassifying Employees and Contractors

For owners of businesses big and small, failure to get your taxes right can be an expensive mistake. Employee misclassification is one such example, and errors can result in massive fines, unwanted taxes, and class action lawsuits as well as a damaged reputation as an employer.

With more companies today choosing to leverage freelancers and independent contractors, the importance of compliance when it comes to classifying workers has never been more pertinent.

So what is the definition of a misclassified worker? What exactly are the risks and penalties, and how can employers make sure they correctly classify their workers? Let’s dig into the details and get clear on these questions and more.

What Is a Misclassified Worker?

Misclassification is when an employer fails to correctly classify a worker for tax purposes. This often occurs when an employer considers a worker to be an independent contractor rather than an employee. In many cases, this is done intentionally to reduce costs and taxes, but it’s also possible to accidentally misclassify an employee as a contract worker. 

Importance of correct classification

It’s vital to correctly classify workers for several reasons. Misclassification negatively impacts workers, and it puts employers at risk of fines and penalties for unpaid payroll taxes. 

First of all, employees won’t be eligible to receive their legal and statutory benefits if they are misclassified as contractors. In particular, they won’t be eligible to receive unemployment benefits or other state-specific benefits for employees if they lose their jobs. They’ll also become responsible for extra Social Security and Medicare payments that employers usually cover. 

Secondly, there are fines and penalties that could be placed upon your business if the Department of Labor or IRS finds evidence of intentional misclassification. These penalties can potentially become extremely costly, putting the stability of your business at risk.

Contractor vs Employee

Generally speaking, the biggest difference between contractors and employees is that contractors set their own work schedules and are considered to be self-employed. Contractors pay self-employment taxes, and their clients don’t need to withhold taxes from their payments like employers do.

On the other hand, employees typically work according to a given schedule. They often sign a contract of employment, detailing that they are considered an employee of said company for a specified period of time. Employees also receive statutory benefits such as access to unemployment insurance, and their employers withhold Social Security, Medicare, and income taxes from their salary. Their employers also match their Social Security and Medicare payments.

In most cases, this information is enough to allow employers to easily distinguish between contractors and employees. However, that’s just for normal scenarios. In reality, it’s easy for the line to become blurred when circumstances become more complex and specific.

How the IRS Distinguishes Between Contractors and Employees

The IRS considers the following three relational categories when considering whether a worker should be considered a contractor or an employee:

• Behavioral Control – Does the company have the right to control what the worker does and how the worker does the job? If not, then the worker is likely a contractor.
• Financial Control − Does the business direct or control the financial and business aspects of the worker’s job? Are the business aspects of the worker’s job controlled by the payer? Again, if this isn’t the case, then the worker is most likely a contractor. Contractors typically bear the risk of profit or loss when they take on a job. 
• Relationship of the Parties − Are there written contracts or employee-type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Employee benefits are, of course, available only to employees and not independent contractors.

The IRS may also consider other issues such as whether or not the worker provides their own tools. Usually, this is a sign that the worker is a contractor. 

Consequences of Misclassifying Workers

As we’ve mentioned, one of the primary consequences of misclassifying workers as independent contractors is tax-related. In such cases, an employer’s share of taxes is not paid, and the employee’s taxes are not withheld. This would leave a business liable for employment taxes as well as penalties if an employee were misclassified without good reason. 

By law, employers must withhold and pay income taxes, Social Security, and Medicare taxes from their employees’ pay. They also must match the SS and Medicare payments that they withhold from their employees’ pay, and then, they must pay federal unemployment tax as well as any state employment taxes. 

There are also several penalties for misclassifying employees as independent contractors. The severity of the misclassification penalties depends on several factors, including the size of the business and the length of time these taxes went unpaid. Intentional misclassification can also result in more significant penalties and fines.

Tax Violation Fines

If the IRS were to discover evidence of misclassification, the employer could be subject to the following penalties:

• Up to 3% of the misclassified employee’s wages.
• 100% of the unpaid FICA taxes for that employee.
• Up to 40% of the employee’s FICA taxes that were not withheld.
• $50 for each W-2 tax form that was not filed for the misclassified employee.

Federal Law Violation Fines

In addition to avoiding mandatory taxes, misclassification also violates an employee’s legal federal labor protections. These protections ensure basic and important employment benefits, including overtime pay and compliance with the minimum wage required by state law. 

As a result, the DOL takes misclassification very seriously, and the department employs auditors to identify and handle misclassification on a regular basis. At the very least, this manner of federal law violation will require employers to pay back wages, but there may also be applicable criminal penalties, including:

• Up to one year’s jail time
• Penalties of up to $1,000 per misclassified employee
• Class-action lawsuits 
• Repayment of benefits insurance, including paid leave, pension, unemployment insurance and more. 
• Further wage claim audits
• Individual misclassification claims

It’s also important to be aware that some states may have specific laws regarding misclassification of employees, potentially leading to further fines and penalties. In short, misclassification can be an extremely expensive situation for employers in both intentional and accidental cases.

In addition to federal and state financial penalties, high-profile cases of misclassification can also cause irreparable damage to a company’s reputation. This could push employees to quit, as well as discourage contractors and employees from working with you in the future.

Voluntary Classification Settlement Program 

If your company needs to reclassify one or more workers, moving from contractors to employees, there is a specific program offered by the IRS to facilitate this. The Voluntary Classification Settlement Program (VCSP) allows business owners to reclassify workers as employees for future tax periods. It also provides partial relief from federal employment taxes for eligible taxpayers who agree to treat their workers, or a certain group of workers, as employees.

There are some eligibility requirements, as well as specific agreements, that must be signed in order to apply for the VCSP. Application is made through IRS Form 8952, Application for Voluntary Classification Settlement Program.

Misclassifying Contractors as Employees

It is also possible, although rare, for employers to accidentally misclassify contractors as employees. Distinguishing the exact nature of a professional relationship can be challenging in some cases, and mistakes can happen. Misclassifying 1099 contractors as W-2 workers isn’t going to bring you massive fines, but it could disrupt your payroll and taxation processes. 

Getting Help with Misclassification of Workers

Either way, misclassification of workers can be a real headache, particularly for small business owners who are swamped on a daily basis. If you think you’ve made a mistake or are otherwise struggling with a misclassification issue, contact us for help. The W Tax Group can help you deal with IRS business tax problems, including fines, penalties, back taxes, and more.

Lead Tax Attorney at The W Tax Group

Stephen A Weisberg