If the IRS determines that you intentionally misclassified a worker as an IC, it will impose a 20% income tax assessment, which means you will be required to pay the IRS an amount equal to 20% of all the payments you made to the worker.
However, this assessment will be reduced or eliminated if you can prove the worker reported and paid income taxes on the payments. Such a reduction is called an offset or abatement.
To obtain this abatement, you must file IRS Form 4669, Employee Wage Statement. This form states how much tax the worker paid on the wages in question. 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.
Unfortunately, by the time your company is audited, typically one to three years after you hired the worker, it may be impossible for you to locate the worker or persuade him or her to complete and sign a Form 4669. This means you’ll be unable to get the abatement.
A better approach is to be proactive and ask workers to sign a Form 4669 as soon as their services end. Retain the signed 4669s in your IC files. This way you’ll be sure to be able to obtain an abatement if the worst happens: You’re audited by the IRS and it claims you have intentionally misclassified the worker.
By April 15 of the year following the year an IC performed services for you, send him or her a blank Form 4669 to fill out and sign. Your IC agreement should contain a provision obligating the worker to provide the information required in the form. (See Independent Contractor Agreements for guidance on creating IC agreements.)
Special Reporting Requirements for California
Beginning January 1, 2001, any business that hires an IC in California must notify the California Employment Development Department (EDD) and let it know some basic information about the IC, including how much the IC is being paid. This rule applies to any IC for whom the business must file IRS Form 1099—in other words, to any IC whom the business pays $600 or more in the course of a year. The EDD and other California state agencies will use this information to aid in the enforcement of child support orders issued against ICs. The information is not supposed to be used for any other purpose—for example, as an audit lead.
A California business that uses an IC does not need to file the EED report at the same time that it files the 1099 form. Rather, the EDD reports must be filed within 20 days after the business:
- enters into an oral or written contract or contracts with an IC in California in which it promises to pay the IC a total of $600 or more for his or her services, or
- actually pays an IC $600 or more; if the business makes multiple payments to the IC, the business must file the form within 20 days after the total payments reach or surpass $600.
- Thus, if a business uses many ICs, it will likely have to file EDD reports at various times throughout the year.
- The business must give the EDD the following information:
- the IC’s full name and Social Security number
- the business’s name, address and telephone number
- the business’s federal employer identification number, California state employer account number, Social Security number or other identifying number as required by the EDD
- the date the contract was signed, or if there is no contract, the date the payments to the IC reach or surpass $600, and
- the total dollar amount of the contract, if any, and the contract expiration date.
The EDD will retain information until November 1 following the tax year in which the contract is entered into, or if there is no contract, the tax year in which the payments to the IC exceeded $600.
The EDD has created a form for hiring firms to use to comply with these reporting requirements. It is Form DE 542, Report of Independent Contractor(s). You can download a copy from the EDD website at www.edd.cahwnet.gov/txicr.htm. You can also obtain a copy by calling the EDD at 888-745-3886 or by visiting your local employment tax office. Look in the state government section of your telephone article under “Employment Development Department.”