Today more and more businesses are making increasing use of outside workers to cut costs, including payroll tax costs. Unfortunately, this trend has caught the attention of the IRS. What the IRS is looking for are workers who are treated as independent contractors but who are employees. If the IRS is successful in reclassifying workers, there is the potential of a substantial tax bill, consisting of, just for starters, the employer’s back social security taxes and FUTA taxes, plus possible penalties and interest.
The amounts involved are significant. For 2021, in addition to income tax withholding, the employer is required to withhold 6.2 percent from taxable wages up to a wage base of $142,800 for the Old Age, Survivors and Disability and Insurance (OASDI) portion of the Federal Insurance Contributions Act (FICA). The Hospital Insurance (HI, or Medicare) portion of the tax has no wage cap.
Despite the high stakes, classifying a worker as either an independent contractor or an employee is not straightforward. The determination depends on several factors and can be quite complex. Control of how and when the worker gets the job done may or may not be the most important factor. Some workers are employees no matter how little or how much they are supervised. Others are independent contractors no matter how tightly a business controls them. For many years, the IRS applied a 20-factor control test as an analytical tool. The IRS has attempted to simplify this test by examining evidence of the degree of control and independence based on three categories: (1) behavioral control, (2) financial control, and (3) the relationship of the parties.
There is some good news in all this intricacy. First, taxes due may be reduced if the misclassification is unintentional. Second, in some cases, if you have always treated workers as independent contractors the IRS may let you go on doing so. You cannot take advantage of this safe harbor unless there was a reasonable basis for not classifying the individual as an employee in the first place and unless you have filed all returns required for nonemployees, such as Form 1099 information returns. Third, if you are unable to meet all the requirements but have filed returns, the IRS may let you settle for a fraction of the cost. Of course, there are times when the IRS is incorrect in its demands for reclassification and litigation, rather than quick settlement, may be the better course of action.
Contact the Crosslin tax team and we can work with you to review existing payment arrangements, help you with future plans and advise you what, if any, action is necessary. We may even find workers are independent contractors who have been misclassified as employees. We are here to help!