The tax attorneys at Nardone Limited often assist taxpayers throughout the Internal Revenue Service (“IRS”) auditing and examination process. Frequently, IRS audits and examinations involve worker classification issues. Despite government efforts to end misclassification through increased enforcement efforts, the misclassification of employees as independent contractors persists. For tax purposes, this means that the employer—because it classified a worker or group of workers as independent contractors—did not withhold any employment taxes. This is okay, as long as the IRS also agrees that the worker or group of workers are in fact independent contractors and not employees. But, if the IRS finds that the employer had no reasonable basis for classifying the employee as an independent contractor, the employer may be held liable for employment taxes for that misclassified worker.
Penalties for Unintentional Failures to Pay and Withhold Employment Taxes
If an employer fails to deduct and withhold income tax on an employee’s wages by reason of treating the worker as an independent contractor, the employer’s liability for income tax withholding is limited to 1.5% of the wages. IRC §3509(b)(1)(A). But, the IRS may increase that liability to 3% if the employer did not meet the applicable requirements, such as filing Form 1099-MISC. IRC §3509(b)(1). Further, the employer is also responsible for unpaid social security tax, at an assumed rate of 20%. IRC §3509(a)(2). But, the assumed rate of 20% will increase to 40% if the IRS finds that the employer failed to meet the applicable requirements. IRC §3509(b)(1)(B). The IRS, however, will grant relief to employers who can show that it had a reasonable basis for classifying the worker as an independent contractor. The employer must show that it exercised ordinary business care and prudence in determining its tax obligations, but nevertheless failed to comply with those obligations.
“Reasonable Basis” Relief
Section 530 of the Revenue Act of 1978 provides relief to employers for unpaid employment taxes if the employer is able to meet a three part test. For an employer to be granted relief under §530 it must prove the following:
- Reporting consistency;
- Substantive consistency; and
- Reasonable basis.
An employer may demonstrate reporting consistency, by showing that it timely filed the requisite information returns consistent with the employer’s treatment of the worker as an independent contractor. Secondly, the employer must show that it treated the worker and any similar workers, as independent contractors. If the employer treated similar workers as employees, §530 relief may not be available. Finally, the employer must have had a reasonable basis for not treating the workers as employees. The IRS has listed the following as acceptable justification for showing reasonable basis: (i) the employer reasonably relied on a court case or a ruling issued to the employer by the IRS; (ii) the employer was previously audited by the IRS at a time when the employer treated similar workers as independent contractors and the IRS did not reclassify those workers; and (iii) the employer relied on advice provided by an attorney or accountant. IRS Pub. 1976 (Rev. 1-2017).
The laws regarding worker classification are complex and unclear. Misclassifying a group of workers for an extended period of time could lead to substantial and unexpected payments to the IRS if the employer is unable to show that it had a reasonable basis for misclassifying an employee or group of employees. Employers must not only consider the possibility of the IRS conducting an audit, they must also consider the possibility that a worker may file a complaint. Workers who suspect they have been misclassified by an employer are able to file a complaint with the Department of Labor. The filing of a complaint by a misclassified worker, or group of workers, may give the IRS cause to audit the employer. For these reasons, it is necessary that employers understand the associated risks of classifying workers and the importance of seeking guidance from a legal professional when making those decisions.
Nardone Limited Comment: Although the laws regarding worker classification are complex, there are instances where the law is very clear on determining whether certain workers are employees or independent contractors. As an example, see our prior blog on treating dental hygienists as independent contractors versus employees.
Contact Nardone Limited
Nardone Limited represents employers with federal tax issues, including proper worker classifications for IRS audits and examinations. If your business is subject to IRS taxes and penalties for improper worker classification, you should contact an experienced tax attorney today. Nardone Limited’s tax attorneys and professionals are well experienced with representing clients before the IRS. Our experienced tax attorneys will thoroughly review your case to determine what options and alternatives are available. Contact us today for a consultation to discuss your case.