The Internal Revenue Service estimates it has lost $34.7 billion in unpaid taxes because contractors have been misclassified as 1099 independent contractors (IC) instead of W-2 employees. In one year, the Government Accountability Office estimated that misclassification cost the federal government $4.7 billion in income taxes. Worker misclassification is one of the major IRS audit red flags, and could be one of the employment laws you might be breaking. Understandably, the IRS has made it a priority to investigate the issue of worker misclassification and has ramped up their audit staff.
The IRS is sharing information with Federal agencies like the U.S. Department of Labor, to determine if overtime laws, minimum wage laws or prevailing wage laws are being followed.
The IRS is also communicating with state agencies that administer taxes. Employers who are found to have violated state labor laws will be required to pay back taxes, back wages, unpaid workers’ compensation premiums and unemployment premiums. Depending on which law was violated, there is a potential for additional liability. Several states have made worker misclassification a priority and the penalties are getting more severe.
The topic of proper worker classification has quite a history. In 1987, the IRS published a 20-factor test to help determine whether or not a worker was a common law employee. However, in 1996 the IRS restructured the test into three main categories — behavioral control, financial control and type of relationship. This is discussed in an IRS article . The degree of control the business has over its workers is a key factor. Generally, the more control a business has over a worker, the more likely it is that the worker is an employee rather than an independent contractor.
An IRS audit can be triggered by any number of things, but some common occurrences that may flag your company for an audit includes:
- The 1099 IC files a claim for unemployment benefits. (They are not eligible for unemployment.)
- The 1099 IC files a claim for workers’ compensation or disability benefits. (They should carry workers’ compensation on themselves because they are not eligible through an employer.)
- A worker receives a W-2 and a 1099 Form from the same employer in one year because they converted from a 1099 IC to a direct hire of the company. (If they are performing the same task as a 1099 IC and W-2 employee, they are normally classified as W-2 employees.)
- The worker feels they are being improperly treated as a 1099 IC and files a complaint with the Department of Labor’s Wage and Hour Division.
- The worker feels they are being improperly treated as a 1099 IC and files a Form SS-8 with the IRS for their own classification determination, or files a Form 8919, Uncollected Social Security Tax and Medicare Tax on Wages, with their personal income tax return.
- The IRS is anonymously alerted about the worker or the employer not paying taxes.
- Additional Initiatives
A further illustration of the growing relationship between the IRS and other initiatives include:
- Questionable Employment Tax Practices (QETP) Initiative
- IRS National Research Program (NRP)
- The 1099 Matching Program
- The Employment Tax Examination Program
[ Debbie Fledderjohann of Top Echelon contributed to this article. ]