One of the most common areas of contention between the IRS and businesses is the issue of worker classification. If a worker is an employee, the business is responsible for payroll taxes and fringe benefits. However, if the worker is an independent contractor, the business is generally not responsible for payroll taxes.

The IRS estimates millions of workers are miss-classified as independent contractors, depriving the federal government of huge sums of tax revenue. Consequently, the IRS is focusing on worker classification issues and has several audit initiatives in progress.

If a business incorrectly treats an independent contractor as an employee, the business will unnecessarily pay FICA and FUTA taxes and collect FIT withholding. However, if the business incorrectly treats an employee as an independent contractor, the business –

  • may risk increased income and FICA taxes, penalties, and interest;
  • may owe back FUTA taxes, with penalties and interest;
  • may owe back pay and overtime under wage and hour laws;
  • may jeopardize qualified benefit plans;
  • may jeopardize other benefit plans;
  • may be liable for the retroactive effect of relassifying workers under state workers’ compensation and disability statutes, and state mandated benefits (such as parental leave or vacation time);
  • may not be in compliance with other federal laws that only apply if the number of employees equals or exceeds certain thresholds (OSHA, ADA, FMLA, etc.); and
  • may face other risks
    [for example, increased business liability for workers’ actions and liability for failing to obtain a Form I-9 (Employment Eligibility Verification) upon hiring the worker].

Classifying workers incorrectly can have significant consequences – from past due payroll taxes to fringe benefit plans. Thus, businesses should exercise due diligence when classifying workers as independent contractors.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the Internal Revenue Service Circular 230, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, by any person for the purpose of (i) avoiding tax-related penalties or (ii) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.