Are you looking to classify your workers as independent contractors?
As a follow-up to our last blog about when to obtain Form W-9, an equally important question is “who qualifies as an independent contractor?” The wrong answer can lead to a painful assessment from the IRS.
It is important you understand the independent contractor definition. An easy way to do so is to review an independent contractor test and independent contractor vs. employee checklist.
Even if an employer correctly followed the independent contractor rules and issued a 1099-MISC, that employer will face a withholding tax liability equal to 1.5% of the payments made to such employee if the employer “misclassified” the employee. Additionally, the employer will face a Social Security tax in the amount of 20% of the employee’s FICA tax liability.
If the employer did not follow all the correct reporting requirements for an independent contractor, the withholding tax doubles to 3% of the payments and the Social Security tax doubles to 40% of the employee’s share of FICA tax liability.
If the IRS disagrees with an employee’s classification, the employer must pay the tax, no matter how much effort went into determining the correct classification.
The employer may not be totally out of luck, though. Read on!
The taxpayer may subsequently bring an action to recover those taxes under Section 530 of the Revenue Act of 1978, which may provide tax relief to the employer only after it has both:
- established that it has filed all the required returns consistent with treating the worker as an independent contractor, and
- shown that it did not treat any other worker performing the same duties as an employee.
Once these two requirements are met, the employer may be entitled to relief from the federal employment tax liability under Section 530’s statutory requirements, but the employer must show it had a “reasonable basis” for not classifying the worker as an employee.
The employer must show that:
- a judicial precedent, published rulings, technical advice, or a letter ruling to the taxpayer (employer) exists, or
- the IRS previously audited the taxpayer
- the IRS determined that the taxpayer’s workers were independent contractors
- the workers, subject to the prior audit, are similar to the workers at issue, and
- the taxpayer treated the two groups of workers in a similar fashion, or
- there is a long-standing practice of a significant segment of the industry in which the individual was engaged.
Even if a taxpayer does not meet the above statutory safe harbor categories of Section 530, courts may be willing to provide relief to employers that put in a reasonable effort to determine the proper classification of its employees.
Note: Section 530 only applies to tax relief. It does not address whether the classification of that employee is correct. Even if an employer successfully receives tax relief, it may still have to classify its workers as employees.
If you have questions about classification, contact Donovan & Limroth for assistance. And for more resources on this topic, visit the IRS website.