Employee Misclassification: Avoiding IRS consequences
What happens if you thought you had an independent contractor, but after a bit of research, you come to find that the worker is an employee? Unfortunately, the IRS has become stricter on this issue in recent years after they discovered billions of dollars were being lost due to employee misclassification. Not only are there IRS implications, but you will also find yourself penalized by the IRS, and your state government.
EMPLOYEE VS CONTRACTOR - WHICH IS WHICH?
When you misclassify a worker, intentionally or unintentionally, it impacts your employees, your business partners, and the government. During the hiring process, you need to do your research to ensure you are labeling your relationship in the appropriate manner. Read about the difference between an employee and an independent contractor here.
EMPLOYEE MISCLASSIFICATION PENALTIES TO AVOID
As a business, misclassifying an employee can leave you liable for IRS penalties later on. For example, when you have an independent contractor you don’t have to pay benefits, Social Security and Medicare taxes, as well as other ‘standard employee costs’. But what happens when the IRS finds that your so-called independent contractor is an employee after all? Well, you’re going to end up paying quite a bit in penalties. The amount you’ll pay the IRS depends on whether or not they find that you were intentional in the employee misclassification or not, but we’ll talk more about that later.
THE EFFECTS OF EMPLOYEE MISCLASSIFICATION
An employee who is misclassified loses out on a lot of benefits of the typical employer-employee relationship. Some common things they may not receive if they are misclassified as an independent contractor are:
Minimum wage
Overtime pay
Employer-sponsored benefits
Unemployment insurance
Workers’ compensation
Tools to perform the job
Also, if employee misclassification occurs it could double the amount of Social Security tax due to workers.
The government also suffers from employee misclassification, as income from Social Security, Medicare, and other employment taxes are not being collected. This results in a major loss for the government which makes taxpayers suffer and hurts the economy.
EMPLOYEE MISCLASSIFICATION AND THE IRS
The IRS handles employee misclassification differently based on whether they can prove it was intentional or unintentional. If the misclassification of an employee was unintentional the Internal Revenue Code has special assessments for tax reduction:
For not withholding federal tax income, the tax assessed is 1.5% of wages paid. If the employer fails to file an information return (Form 1099) with the IRS, the assessment is 3%.
For not withholding the employee’s share of Social Security and Medicare taxes, the tax assessed is 20% of the employee’s share. If the employer fails to file an information return (Form 1099) with the IRS, the assessment is 40%. The employer’s share of Social Security and Medicare taxes must also be paid.
If an employer misclassifies an employee as an independent contractor even after they determined an employer-employee relationship existed, the above assessments do not apply. If employee misclassification was intentional, the employer is responsible for the full amount of federal income tax that should have been withheld and the full amount of the employee’s and employer’s share of Social Security and Medicare taxes. Not only that, but the employer can also face penalties for failing to file returns and pay taxes, and penalties at the state level for failure to withhold and pay taxes.
The IRS has a few chosen methods that help detect employee misclassification. For example, if an individual only files one Form 1099 with their tax return, the IRS will investigate that. A person who only receives payment from one company could actually be an employee rather than an independent contractor. The IRS also watches for workers who submit both a 1099 and a W-2 from the same company within the same year. While it is ok for a worker to be an employee and an independent contractor for the same business within the same year, this will prompt the IRS to investigate this. The IRS will also conduct an audit to uncover employment status designations.
HOW TO CORRECT EMPLOYEE MISCLASSIFICATION
CONVERTING AN INDEPENDENT CONTRACTOR TO AN EMPLOYEE
If you discover that you need to switch your independent contractor to an employee, there will be a little bit of work involved in doing so. You will need to notify the contractor in writing of your intent to convert them from their current status of ‘contractor’ to ‘employee’. They may need to provide additional identification in order for you to implement this change. It is a good idea to provide a timestamp on this written document in case you need that information in the future.
You will need to set up a new employee file within your database and indicate whether the employee will be salary, salary exempt, or hourly non-exempt. It is recommended that during this process you check the US Department of Labor guidelines to be sure you are choosing the right classification. Next, you will set up a pay frequency for the contractor-turned-employee. If the employee will be hourly, or salary exempt, be sure to set up overtime calculations within your payroll software if the employee works more than 40 hours in a given week. Our recent blog on choosing the right pay frequency for your organization provides some useful guidance on this.
Do not forget to have the employee fill out a W-4 Form so that you will know their tax withholding information. If you are currently using software to run your payroll, this information will need to be entered into the payroll software in order to accurately calculate tax withholding amounts. At the end of the year will you be responsible for producing a W-2 Form for your employee by January 31st. As with any other employee, you will need to also send this W-2 Form to the Social Security Administration and other tax authorities.
If you’re unsure whether or not you need to adjust the classification of an independent contractor you should first run through the tools and tests provided by the IRS.
HOW AAB PAYROLL CAN HELP
Getting employee misclassification wrong can have serious consequences. If you still don't know whether you have employees or independent contractors, our team can provide you with expert guidance.
Arrange a free, no-obligation demo today to see how our software could be of benefit to your organization.
