A lot of businesses practice employee misclassification, an illegal action that can lead to huge penalties and heavy sanctions. Here is everything you need to know about this, as well as the amnesty program the government has provided for its practice.
In this article:
- What Does Misclassification Mean?
- What Qualifies Someone as an Independent Contractor?
- Why Do Employers Misclassify Employees?
- What Is the Penalty for Misclassification of Employees?
- What Is the Employee Misclassification Amnesty Program?
Employee Misclassification Amnesty Program | What You Need to Know
What Does Misclassification Mean?
Employee misclassification is the wrongful practice wherein employers mislabel their workers as independent contractors.
This practice allows businesses to save money by avoiding numerous labor-related expenses including Social Security and Medicare taxes, unemployment compensation tax, employee benefits, and many more.
What Qualifies Someone as an Independent Contractor?
Differentiating an employee from an independent contractor can be quite complex. It involves various laws, court cases, rules, and different state and federal agencies.
Employers can dictate to independent contractors the scope of work, but generally have no control over how said contractors achieve the results.
Other factors include how the employer pays the worker, the benefits the worker receives, and the written agreements between the worker and the employer. The status of the worker as a separate business, and the allocation of business risk, are also factors to consider.
To further examine this, the IRS has a “right-to-control” test to determine whether workers are employees or independent contractors. According to them, the standards for determining the degree of control and independence fall under the three basic categories below.
- Behavioral Control
The first question asked is whether the employer has the right to control how the worker does the work they were hired for, as well as providing the materials needed to do so.
- Financial Control
Independent contractors often have business expenses the employer does not reimburse. They will also have a significant investment in the tools and facilities they use.
The IRS may classify workers as employees if they have no business expenses and no investments in the tools and facilities they use. Workers who are not free to offer their services to others and who are paid on an hourly basis may also be considered as employees.
- Type of Relationship
Independent contractors are more likely to have a written contract. Often, they will not have benefits provided to employees such as paid vacation or health insurance coverage.
They will not have ongoing relationships with their clients. Their work is also not likely to be a “key aspect” of the business of the client.
Employers need to pay taxes on employees, but not on independent contractors. This is why employee misclassification can result in tax evasion.
Tax Evasion Definition: Tax evasion is an illegal action wherein an entity or individual deliberately misrepresents their true state of affairs to reduce or avoid paying their true tax liabilities. It includes activities such as overstating deductions or declaring lower profits, income, or gains — all of which are subject to significant penalties and criminal charges.
Businesses withhold income from their employees’ wages for Social Security and Medicare taxes. They also pay unemployment taxes, provide workers compensation insurance coverage, and pay the employer’s share of Social Security and Medicare taxes.
Businesses have to abide by labor laws, including policies on minimum wage and overtime laws for their employees.
Workers classified as independent contractors are responsible for filing and paying their own income and self-employment taxes. If workers do not understand or comply with these obligations, they might underpay their taxes.
The majority of state and federal employment laws do not protect independent contractors.
Should these workers get injured on the job, they will not be eligible for workers compensation coverage. They also do not have unemployment benefits if they lose their job.
Why Do Employers Misclassify Employees?
Some employers willfully practice employee misclassification because it saves them money, particularly on labor costs. The largest incentive is that it keeps them from having to pay Social Security and unemployment insurance taxes.
Additionally, employee misclassification allows employers to take advantage of the following:
- It removes their legal responsibilities to their workers like the provision of minimum wage and the abidance to hour laws.
- It lets businesses circumvent laws that the Equal Employment Opportunity Commission (EEOC) enforces to protect employees’ civil rights such as the prohibition of employment discrimination in terms of gender, race, age, or disability.
- Employee misclassification lets businesses prevent the organization of unions or dilution of bargaining units since the National Labor Relations Act does not cover independent contractors.
- Employer-based health and pension plans are inaccessible to independent contractors, letting businesses save money on benefits they provide.
- There are also businesses who practice employee misclassification to avoid the verification of their workers’ citizenship or status. This lets businesses disregard labor laws and exploit low-wage immigrant workers with few legal consequences.
What Is the Penalty for Misclassification of Employees?
Employee misclassification shorts federal and state governments millions of dollars it should have earned from due tax revenues. In fact, the Government Accountability Office estimated that in 2006, the federal government missed $2.72 billion because of employee misclassification.
In response, government agencies perform regular audits to locate misclassified workers. Often, these audits include workers within a three-year period.
Workers who believe they have been misclassified as independent contractors can file complaints with the Department of Labor (DOL).
Misclassification of employees as independent contractors is also detected when workers file for unemployment benefits. Sometimes, they try to file workers’ compensation claims when they are injured during work.
Employee misclassification penalties vary depending on the investigation of the DOL and IRS. The agencies first have to determine whether the misclassification was unintentional, intentional, or even fraudulent.
Employers face the following minimum penalties if the agencies find the misclassification unintentional:
- $50 for every Form W-2 the employer failed to file.
- Penalties amounting to 1.5 percent of the wages, 40 percent of FICA taxes the employer did not withhold, and 100 percent of the corresponding FICA taxes that should have been paid by the employer. Interest also accrues on the penalties for every day that passed since the date these taxes should have been paid.
- Failure to Pay Taxes penalty amounting to 0.5 percent of the unpaid tax liability for every month up to 25 percent of the total tax liability
Employers may also pay penalties of up to $1,000 for every misclassified worker and may even face one year in prison. Additionally, the person responsible for the withholding of taxes can be held personally liable for any uncollected tax.
Employers may face heavier sanctions and penalties should government agencies find that the misclassification was intentional or fraudulent.
What Is the Employee Misclassification Amnesty Program?
The Employee Misclassification Amnesty Program is better known as the IRS’ Voluntary Classification Settlement Program (VCSP). It lets employers reclassify certain workers from independent contractors to employees moving forward, without being liable for any federal employment tax liabilities from previous misclassification.
It lets employers comply with tax laws with a small payment to cover prior payroll tax obligations. The program also lets them avoid bigger penalties that agencies can impose if they wait for an audit.
Employers who participate in the program can take advantage of the following benefits:
- The employer is responsible only for 10 percent of the employment tax liability for the most recent tax year on compensation paid to misclassified employees.
- Employers also avoid penalties and interest on this particular tax liability.
- In exchange for the employers’ agreeing to properly classify their workers for future tax periods, the IRS will also agree not to conduct employment tax audits for worker classification in past years.
To qualify for the program, employers also need to meet the following criteria:
- Employers should have consistently treated their workers as independent contractors for the past three years
- Employers should have filed all required 1099 Forms for these workers during the past three years
- They should not be undergoing a current audit regarding the classification of their workers by either the DOL, the IRS, or any other state agency.
Businesses that engage in employee misclassification can face numerous penalties and sanctions. The IRS’ Employee Misclassification Amnesty Program is a way for businesses to voluntarily correct their mistakes and face much lower penalties than if caught.
Do you have other questions about employee misclassification? Ask us in the comments section below!
If you owe back taxes, visit taxreliefcenter.org for more information on tax relief options.