The IRS and Labor Department have renewed a 2011 Memorandum of Understanding to cooperate on enforcement of worker classification rules, with cross-referrals, investigations and imposition of penalties on noncompliant businesses. The new Memorandum is significant because it signals that the agencies believe worker misclassification is still widespread and businesses are failing to collect proper amounts of employment taxes.
The gig economy, made up of drivers, delivery services and similar flexible arrangements, are testing traditional employer/employee relationships, and the two agencies are trying to keep up with the changes. As the Labor Department said in a news release last year, “Misclassification is a serious issue that denies workers’ rights and protections under federal labor standards, promotes wage theft, allows certain employers to gain an unfair advantage over law-abiding businesses, and hurts the economy at-large.”
For business owners, the new agreement means more scrutiny by the IRS, possible audits and costly enforcement actions for misclassification. Employers should review the status of their employees and contractors now to make sure they are classifying workers properly, using the IRS criteria, explained below.
Independent Contractor or Employee?
Whether a worker is considered an independent contractor or an employee depends on the degree of control the employer has over the employee. The IRS looks at three areas of control:
Behavioral control: Does the company control or have the right to control what the worker does and how the worker does the job?
Financial control: Does the company direct or control the financial and business aspects of the worker’s job? Consider things like how the worker is paid, are expenses reimbursed, who provides tools/supplies, etc.
Relationship of the parties: Are there written contracts or employee type benefits such as pension plan, insurance and vacation pay? Will the relationship continue and is the work performed a key aspect of the business?
These considerations are built into 20 factors the IRS created to evaluate the employer/worker relationship contained in Rev. Rul. 87-41. No one factor is determinative. The IRS will look at the entire relationship.
A decision tree is contained in the new Memorandum that indicates what kind of referrals the IRS is looking for. The IRS does not want referrals:
- that do not involve a determination of worker status
- for businesses that are no longer in operation
- for businesses with $500,000 or less in annual dollar volume (ADV) (The ADV is defined in federal regulations as the gross receipts from all sales or the volume of business done during a 12-month period.).
The IRS also does not want referrals of companies that could qualify for the Sec. 530 “good-faith” relief program, which allows employers to avoid employment tax liability for workers not treated as employees if three statutory requirements are met: 1) the employer has reported the workers’ status consistently on tax forms; 2) the employer treats substantively similar workers consistently and 3) there is a reasonable basis for employer’s classification.
Tax Consequences of Misclassification
The tax consequences of misclassification as independent contractors instead of employees can include:
- imposition of back employment taxes, including social security taxes, Medicare taxes and unemployment taxes
- late fees and penalties
- back benefits for misclassified employees
- criminal penalties for intentional misclassification
Proper worker classification continues to be a compliance priority for the IRS. This is because the IRS believes that the most efficient way to collect employment taxes is to make employers do it for large groups of workers rather than relying on individual independent contractors to file estimated taxes and report themselves. The so-called “1099 workforce” has grown substantially, and recordkeeping and tax filing for these workers is complex, according to the Aspen Institute, a noted think-tank. The complexity results in low compliance and strains IRS resources in pursing individuals.
For businesses, it is critical to correctly determine whether the people providing services are employees or independent contractors. It is important for companies to do an analysis themselves and correct any problems before the IRS targets them for examination. Frazier & Deeter tax professionals can assist with this important evaluation of your employment practices.