Misclassification of Employees As Independent Contractors

Paying workers as contractors 1099s versus wages employees is an age old problem IRS (federal) and EDD (the state) have been chasing for years. EDD seems to have been more aggressive than IRS performing several audits and assessing many companies. Collecting assessments is one of the issues these agencies face. IRS has created a methodology to deal with this called the voluntary classification settlement program. It is not clear cut who is an independent contractor. Simply if you tell a worker what to do and when to do it they are likely employees. Having their own equipment versus using yours having their own insurance and multiple sources of revenue are all factors looked at.

This program will invite companies to change the status of contractors to employees. The calculation is to determine what the payroll taxes would be on the subject wages and then pay 10% of this amount saving 90% of the actual tax. Some reasons IRS would consider this:

1. Full payment could bankrupt some companies
2. IRS incurs large administrative costs to enforce back payroll tax compliance
3. They feel compliance will increase once the change is made
4. IRS has had success with other programs such as the voluntary foreign bank disclosure program

There are certain requirements to be eligible for this program. They must have consistently treated employees as contractors. The company must have filed 1099s for the past three years. They must not currently be under audit by the IRS.

While the IRS is making it easier to change worker classification the state is increasing penalties. California law has increased penalties to range between 5000-15000 per employee and 10000-25000 for those showing a pattern and practice of misclassification. Professionals who advise companies may also now face scrutiny from the state. These new laws seem to undermine the IRS program The state may align with the Federal in time but again sometimes differences exist forever.

Why do folks misclassify workers? Some of it may be lack of knowledge but primarily cost is the driving factor. Payroll taxes are added to wages approximately 10% between federal and state and then insurances like liability and workers compensation are added. I also think small business owners do not like continual touch with the IRS and EDD.

News flash the state of California is in need of money and has long targeted this area more than IRS. It is ironic while IRS is making it easier to reclassify workers the state is doing the exact opposite with their increased costs and with these new developments companies will need to closely evaluate this area. I have known businesses who have faced this tax audit and the result was quite devastating. The business that does pay contractors this way should be sure to issue 1099s as this is a requirement to qualify for the federal program and also encourages the recipient to file a tax return and report the income. If not you may be liable for the income taxes also as upon audit they assess this too and are willing to back out the anyone who they can prove filed and paid the tax.

In closing the IRS wants the new form filed 60 days before you elect to reclassify your subcontractors. Their instructions use August 1st 2012 which seems to encourage to wait on compliance until October 2012 the start of the last quarter of the calendar year. Personally I like the approach to get companies in the system which means they hopefully will continue for many years to come. Since they have a hard time collecting big assessments why not get something now and much more go forward. I do not frequently compliment the IRS, but my hats is off to them on this one and hopefully we will see many more businesses seek compliance which will give them peace of mind and our economies more revenue to support our budgets.

Author: Stephen Williams, CPA, Partner