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Costly Misclassifications

The IRS offers guidance for such snafus.

By John Balitis and Jessica Post
Recent research suggests that an estimated 10 percent to 30 percent of employers misclassify their employees as independent contractors under the Internal Revenue Service (IRS) code’s 20-factor test. This can happen because employers are unsure how to categorize workers because of the required yet complicated multi-factor analysis. In addition, the Department of Labor (DOL), the National Labor Relations Board, the Equal Employment Opportunity Commission, and individual states and their agencies all use slightly different tests to determine whether a worker is an employee or an independent contractor. As a result, it may be possible for an employer have an individual correctly classified as an employee in one context and simultaneously have the same worker classified as an independent contractor in another.

Unfortunately, misclassification under the IRS’s 20-factor test can have significant financial consequences for businesses that are audited. At stake are potentially substantial amounts of back withholding, penalties, and interest, all calculated based on what a business should have paid to the federal government if its worker been properly classified as an employee rather than an independent contractor.

On September 19, 2011, the DOL and the IRS announced an effort to coordinate with one another and with state agencies regarding employers’ misclassification of employees as independent contractors. Given the ever-increasing number of audits being conducted by the DOL, this has potentially serious ramifications for employers. If, for instance, the DOL determines that an independent contractor is misclassified, the DOL now may share that determination and supporting evidence with state agencies, which could very well lead to additional investigations, fines, and liability beyond that imposed by the DOL or the IRS.

On September 21, 2011, within days after cautioning employers about the collaborative enforcement efforts, the IRS announced a new voluntary program to allow employers to reclassify workers who have been improperly classified as independent contractors for employment tax purposes. In general, a taxpayer participating in the Voluntary Classification Settlement Program will be required to pay just more than 10 percent of the employment tax liability (approximately 1 percent of the employees’ compensation) for the reclassified workers for the most recently completed tax year. The employer will not be assessed any interest or penalties, and the employer will not be audited for employment tax purposes for any prior tax years. The total amount paid by the employer is far less than what it would pay following an audit for misclassification of workers.

To participate in this program, the employer must: (1) have consistently treated its workers as independent contractors or other non-employees; (2) have filed all required 1099 forms for its workers for the previous three years; (3) have complied with the results of any previous examination by the IRS or the DOL concerning the classification of workers; and (4) not currently be under examination for the classification of workers by the IRS, the DOL, or a state governmental agency. For the first three years after participating in the program, the employer will be subject to a special six-year statute of limitations for employment taxes (as compared to the usual three years). The employer also will be required to treat reclassified workers as employees prospectively.

The almost simultaneous announcements about planned enforcement efforts and the new amnesty program do not appear to be coincidental. The DOL and the IRS are encouraging businesses to resolve their misclassification violations by making clear what the consequences will be if those errors are left unchecked.

Given these developments, employers should consult with counsel at the earliest opportunity to review the duties and responsibilities of workers who currently are classified as independent contractors for tax purposes and determine whether to take advantage of this program. If this review reveals workers who should be reclassified as employees, the IRS’s voluntary program may provide a mechanism to remedy the situation more efficiently and economically compared to the consequences encountered in an audit process.

Of course, before deciding to participate in the IRS amnesty program, a business also should consider whether converting independent contractors to employees may raise other non-tax concerns. For instance, if the individuals to be converted have worked more than 40 hours per week performing nonexempt duties, the conversion could result in back overtime liability under the Fair Labor Standards Act. Work authorization issues, potential discrimination claims, and benefit plan entitlements and contribution rights also may come into play following the conversion.
John Balitis is a director at Fennemore Craig representing employers in arbitration, litigation and administrative proceedings. He can be reached at Jessica Post is an associate at Fennemore Craig representing in the area of labor and employment law and commercial litigation. She can be reached at


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