The assessments the IRS can impose for worker misclassification vary enormously, depending upon whether the IRS views your misclassification as intentional or unintentional. The most strict penalties, of course, are imposed for intentional misclassification—where you knew the workers were your employees but classified them as ICs anyway to avoid payroll taxes. The IRS will likely conclude your misclassification was intentional if you admit you knew the workers were employees or if it should have been clear to any reasonable person that the workers were employees under the common law test.
EXAMPLE: Bolo Press, a publisher of sports articles, has a six-person production department. Bolo reclassifies its production employees as ICs so it can stop paying payroll taxes for them. After the reclassification, Bolo’s owners treat the production workers just the same as when they were classified as employees—they tell the workers what time to come in and leave, closely supervise their work and give them fringe benefits such as health insurance and pension benefits. The production workers work solely for Bolo and make no attempt to market their services elsewhere.
In an audit, the IRS concludes that the workers are employees. IRS auditors would likely conclude that the misclassification was intentional. Bolo clearly knew the production workers were really employees and reclassified them as ICs in disregard of the law simply to avoid paying payroll taxes.
On the other hand, worker misclassification is unintentional if you believed in good faith, though mistakenly in the view of the IRS, that the workers were ICs. This can involve tricky semantics. The common law test for worker classification used by the IRS is complex and difficult to apply and often does not provide a conclusive answer about how to classify a worker.
Many workers fall into a gray area where it is unclear how to classify them. If you can show that some of the common law factors indicate IC status, your misclassification should be regarded as unintentional. You should be able to do this in all but the most blatant misclassification cases.
1. Penalties for Unintentional Misclassification
When you hire an unincorporated IC, you are normally required to report the payments made to the worker on IRS Form 1099-MISC. There are two ranges of assessments the IRS may impose for unintentional worker misclassification: One is imposed where you filed all required 1099 forms for the workers the IRS claims you misclassified, and the other is imposed where you did not file the 1099 forms.
a. 1099 forms filed
If 1099 forms were filed, you will be required to pay a sum equal to:
- 20% of the FICA taxes (Social Security and Medicare) the employees should have had withheld from their pay—that is, 1.24% of the misclassified workers’ wages up to the FICA Social Security tax ceiling plus 0.29% of all the workers’ wages, plus
- 100% of the FICA taxes you should have paid on the workers’ behalf as their employer —that is, 6.2% of the employees’ wages up to the Social Security tax ceiling plus 1.45% of all the employees’ wages, plus
- 1.5% of all the wages that were paid to the misclassified workers—a penalty for your failure to withhold federal income taxes from the workers’ paychecks, plus
- all FUTA taxes (federal unemployment taxes) that should have been paid—the FUTA tax rate is 6.2% of the first $7,000 in employee wages, or .08% of the first $7,000 if the applicable state unemployment tax was timely paid; if a worker was paid $7,000 or more for a year, this amounts to either $434 or $56.
FICA Social Security Tax Ceiling
FICA taxes actually consist of two separate taxes: a 6.2% Social Security tax and a 1.45% Medicare tax on both the employer and employee. There is a ceiling on the Social Security tax—that is, a salary level beyond which the tax need not be paid. The ceiling increases every year. In 2003, the ceiling was $87,000. However, the Medicare tax must be paid on all the compensation paid to an employee.
You must pay the assessments for your failure to withhold employee FICA and income taxes from misclassified workers’ compensation even if the workers paid all these taxes themselves. And these assessments will not be reduced where you can prove the workers paid the taxes. This means that the IRS could end up collecting more tax than would have been due had you classified the workers as employees and paid payroll taxes.
Together, these assessments amount to 16.88% of the compensation you paid each misclassified worker up to the $7,000 FUTA tax ceiling and then 10.68% of compensation up to the FICA Social Security tax ceiling. Any payments to a worker in excess of the Social Security tax ceiling are assessed at a 3.24% rate.
EXAMPLE: The IRS decides that Acme Sandblasting Corporation unintentionally misclassified five workers as ICs during 2003. Acme paid each worker $20,000 during that year and reported the payments on Form 1099. Based on this $100,000 in payments, the IRS assessment would be $12,620. This is calculated as follows:
20% of employee FICA tax = $1,300
100% of employer FICA tax = $7,650
1.5% of all employee wages = $1,500
6.2% FUTA tax for five
workers each paid $20,000 = $2,170
b. 1099 forms not filed
If you failed to file the 1099 forms, the employee FICA and income tax assessments are doubled. You must pay a sum equal to:
- 40% of the FICA (Social Security and Medicare) taxes the employee should have had withheld—that is, 2.48% of the misclassified workers’ wages up to the FICA Social Security tax ceiling plus 0.58% of all the workers’ wages, plus
- 100% of the FICA taxes you should have paid on the misclassified workers’ behalf as their employer—that is, 6.2% of the employees’ wages up to the Social Security tax ceiling plus 1.45% of all the employees’ wages, plus
- 3% of all the wages that were paid to each misclassified worker as a penalty for your failure to withhold federal income taxes from the workers’ paychecks, plus
- all FUTA taxes that should have been paid—6.2% or .08% of the first $7,000 in compensation.
EXAMPLE: Recall the example above, in which $12,620 was assessed on $100,000 in payments to five misclassified workers. If, however, you did not file Form 1099 for those workers, you’d have to pay $15,880. This would break down as follows:
40% of employee FICA tax = $3,060
100% of employer FICA tax = $7,650
3% of all employee wages = $3,000
6.2% FUTA tax for five
workers each paid $20,000 = $2,170
2. Penalties for Intentional Misclassification
IRS assessments are far higher if the IRS concludes that you intentionally misclassified as ICs workers you knew to be employees. You will be required to pay out of your own pocket all the FICA tax that you should have withheld from the employees’ paychecks. You must pay:
- 100% of the FICA (Social Security and Medicare) taxes the misclassified workers should have had withheld—that is, 7.65% of the employee’s wages subject to FICA, plus
- 100% of the FICA taxes you should have paid on the workers’ behalf as their employer—that is, 7.65% of the employee’s wages subject to FICA, plus
- 20% of all the wages that were paid to the workers to make up for your failure to withhold federal income taxes from their paychecks, plus
- all FUTA taxes that should have been paid—6.2% of the first $7,000 in worker compensation or .08% if state unemployment taxes were paid.
Together, these assessments amount to a whopping 41.50% of worker compensation up to the $7,000 FUTA tax ceiling and then 35.3% of payments up to the Social Security tax ceiling.
Comparing these assessments with those that can be imposed for unintentional misclassification is a sobering exercise. As illustrated above, if you paid $100,000 to five workers the IRS claimed you unintentionally misclassified as employees during 2002, the assessments would total $12,620 if you filed 1099 forms, or $15,880 if you failed to file 1099 forms. But if the IRS claims you intentionally misclassified the workers, the assessments would total $37,470. This breaks down as follows:
100% of employee FICA tax = $7,650
100% of employer FICA tax = $7,650
20% of all employee wages = $20,000
6.2% FUTA tax for five workers
who were each paid $20,000 = $2,170
a. Offsets for worker income tax payments
The only good thing about the intentional misclassification assessment is that the income tax portion can be reduced if you can prove that the misclassified worker paid his or her income taxes for the years in question. Such a reduction is called an offset or abatement.
The IRS will not help you prove income taxes were paid. IRS examiners will not request that workers provide copies of their income tax returns nor will the IRS give these returns to you. Instead, you need to file IRS Form 4669, Employee Wage Statement. This form states how much tax the worker paid on the wages. The worker must sign the form under penalty of perjury. You must file a Form 4669 for each worker involved along with Form 4670, Request for Relief From Payment of Income Tax Withholding, which is used to summarize and transmit the Form 4669.
The IRS examiner has the discretion to accept Forms 4669 and 4670 before the examination is closed and reduce the assessment. Otherwise, you must file them with your IRS service center.
EXAMPLE: The IRS determines that Acme Sandblasting Corporation intentionally misclassified a computer consultant as an IC in 2002. Acme paid the worker $100,000. The IRS assessment is $30,848.40. However, the consultant paid all income taxes due on her compensation. Acme has the consultant sign IRS Form 4669 and submits it to the examiner along with Form 4670 before the IRS examination is closed. The examiner wipes out the entire 20% income tax penalty. The assessment is reduced by $20,000.
b. Offsets for worker FICA tax payments
Theoretically, if the misclassified workers paid their FICA taxes, you may also be entitled to an offset of the employee FICA portion of the assessment. However, in practice, this offset is difficult or impossible to obtain because a misclassified worker has a right to claim a refund for all the self-employment taxes he or she paid for the years covered by the audit. If the worker claims the refund, you can’t get the offset. Because of this right, the IRS will not give you an employee FICA offset unless the misclassified worker fails to file a claim for a refund of these taxes within the statutory time limit, either two or three years.
Intentional Misclassification Assessments May Be Lower
Oddly, if you are able to get an offset for the income tax portion of an intentional misclassification assessment, the final assessment may be less than that which could be imposed for an unintentional misclassification. However, you are not allowed to choose which assessment rules will be used. If your misclassification was unintentional, the assessment rules will apply and you will not be entitled to any offsets. Some hiring firms have actually attempted to convince the IRS that a misclassification was intentional so that they could obtain assessment offsets.