In addition to the assessments discussed above, the IRS has the option of imposing an array of other penalties on hiring firms that misclassify workers.
1. Trust Fund Recovery Penalty
As far as the IRS is concerned, an employer’s most important duty is to withhold FICA and income taxes from its employees’ paychecks and pay the money to the IRS. Employee FICA and federal income taxes are also known as trust fund taxes because the employer is deemed to hold the withheld funds in trust for the U.S. government. The IRS considers failure to pay trust fund taxes to be a very serious transgression.
The IRS may impose a penalty known as the trust fund recovery penalty, formerly the 100% penalty, against individual employers or other people associated with the business. These are people the IRS deems responsible for failing to withhold employee FICA and federal income taxes and pay the withheld sums to the IRS. Failure to pay payroll taxes is willful if you knew the taxes were due and didn’t pay them. The IRS will conclude you have acted willfully if you should have known the workers involved were employees, not ICs.
The trust fund recovery penalty is also known as the 100% penalty because the amount of the penalty is equal to 100% of the total amount of employee FICA and federal income taxes the employer failed to withhold and pay to the IRS. This can be a staggering sum.
EXAMPLE: The IRS determines that Acme Sandblasting Corporation intentionally misclassified a computer consultant as an IC in 2002. Acme paid the consultant $100,000. The IRS decides to impose the trust fund recovery penalty against Acme. Acme should have withheld and paid to the IRS $7,650 in employee FICA taxes and withheld $25,000 in federal income taxes, for a total of $32,650 in trust fund taxes. The 100% penalty is $32,650.
a. Liability for 100% penalty
If you’re a business owner, you’ll be personally liable for the 100% penalty—in other words, you will have to pay it out of your own pocket. Business owners include sole proprietors, general partners and corporate officers such as the president, vice president, secretary and treasurer, whether or not they own any stock.
However, the scariest thing about the trust fund recovery penalty is that nonowner employees such as office managers, accountants, bookkeepers and even some clerks may also be held personally liable for it. They may be on the hook if the IRS concludes they willfully prevented the IRS from collecting the unpaid payroll taxes—in other words, they knew the taxes were due and didn’t do anything about it. Most vulnerable are those who:
made the business’s financial decisions
had authority to sign checks
had the power to decide which bills to pay, or
signed the business’s payroll tax returns, such as the quarterly IRS Form 941.
b. Appealing a penalty
If an IRS revenue officer decides you are responsible, you will be sent a notice and tax bill. You are entitled to appeal the penalty and have a hearing before an IRS appeals officer. You must file an appeal within 30 days.
Resources
For a detailed discussion of IRS appeals, see Stand Up to the IRS, by attorney Frederick W. Daily (Nolo).
2. Other Penalties
The IRS has the option of imposing many other penalties on hiring firms that misclassify workers. These include:
- A $50 penalty for each W-2 that you failed to file for misclassified workers. The penalty is larger if the failure to file was intentional. (IRC 6721.)
- A $50 penalty for each W-2 you failed to send a misclassified employee. The penalty is $100 if the failure to file was intentional. (IRC 6722.)
- A $50 penalty for each 1099 form you failed to file. (IRC 6721.)
- If the IRS determines you intentionally disregarded the rules requiring 1099 forms to be filed, a penalty equal to the greater of $100 or 10% of the compensation paid the worker can be imposed. (IRC 6721(e)(1).)
- If employment tax returns were not filed, a delinquency penalty of up to 25% of the tax determined to be due. (IRC 6651(a)(1).)
- A penalty for failure to pay taxes of 1/2% per month on the unpaid taxes for up to 50 months. (IRC 6651(a)(2).)
- For failing to deposit the taxes found to be due, a penalty of up to 15% of the additional tax. (IRC 6656.)
- For negligently or intentionally disregarding IRS rules and regulations, a penalty of up to 20% of the underpayment that is due to the negligence. (IRC 6662.)
- A fraud penalty of 75% of the underpayment if the IRS determines that the underpayment is due to fraud; no negligence penalty is imposed in this event. (IRC 6663.)
Generally, the more severe penalties are imposed only where you intentionally misclassified workers.