IRS reclassification
Encyclopedia
IRS reclassification as an employee occurs where persons claimed as (or claiming to be) independent contractors are recategorized by the Internal Revenue Service
(IRS), or by state tax authorities, as W-2 employees. The reclassification can result in the imposition of fines, penalties, and back-taxes for which the employer is generally liable. These amounts could cost a business large sums of money. The U.S. Government Accountability Office
(GAO) (formerly known as the General Accounting Office) reports that the IRS claims to lose millions of dollars in uncollected taxes because of misclassification of independent contractors by taxpayers.http://www.gao.gov/archive/1996/gg96130t.pdf According to IRS Commissioner
Mark W. Everson
in a statement made November 3, 2005, IRS audits of small businesses organized as corporations increased from 7,294 in 2004 to 17,867 in 2005. http://www.irs.gov/newsroom/article/0,,id=150358,00.html
es (i.e. Social Security
and Medicare
taxes, unemployment tax
es, etc.) on the wages of a worker that is classified as an employee. However, these same taxes are generally not paid by the employer on the compensation of a worker classified as an independent contractor. If an employer intentionally or mistakenly classifies an employee as an independent contractor, the employer is then at risk for being heavily fined and paying back-taxes.
Being classified as an independent contractor also affects whether an employee can receive unemployment benefits. In many states, independent contractors are not eligible for unemployment benefits because nothing has been paid into the unemployment insurance fund on their behalf. Employers who have no W-2 employees are not required to make payments to the unemployment insurance fund, and since no one can file a claim for benefits, they don't have to worry about their accounts being charged any extra. So should a misclassified employee lose his job through no fault of his own, that employee has no recourse with the Department of Labor and no unemployment benefits upon which to fall back.
Construction workers are often the most misclassified workers in the industry of the United States, Europe, and the Middle East. Workers are misclassified for the employers to reap a different benefit, such as paying fewer taxes and paying less benefit, and workers are paid incorrectly. Organizations fighting against this fraud are shown below.
list, or whose services are on an exempt services list, may not require an evaluation. Also, independent contractors immediately willing to become W-2 employees through a Portable Employer of Record will not require an evaluation.
If the analysis is necessary, a qualified Compliance Officer attempts to produce an accurate judgment of the workers classification, and delivers his or her written recommendation to the employer.
A Compliance File, including all necessary supporting documentation for the compliant independent contractor, is kept on file in the event of an audit
.
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
(IRS), or by state tax authorities, as W-2 employees. The reclassification can result in the imposition of fines, penalties, and back-taxes for which the employer is generally liable. These amounts could cost a business large sums of money. The U.S. Government Accountability Office
Government Accountability Office
The Government Accountability Office is the audit, evaluation, and investigative arm of the United States Congress. It is located in the legislative branch of the United States government.-History:...
(GAO) (formerly known as the General Accounting Office) reports that the IRS claims to lose millions of dollars in uncollected taxes because of misclassification of independent contractors by taxpayers.http://www.gao.gov/archive/1996/gg96130t.pdf According to IRS Commissioner
Commissioner of Internal Revenue
The Commissioner of Internal Revenue is the head of the Internal Revenue Service , a bureau within the United States Department of the Treasury.The office of Commissioner was created by Congress by the Revenue Act of 1862...
Mark W. Everson
Mark W. Everson
Mark W. Everson serves as a cabinet member for Indiana Governor Mitch Daniels. He joined the Daniels administration in January 2009, when he was appointed Department of Administration Commissioner...
in a statement made November 3, 2005, IRS audits of small businesses organized as corporations increased from 7,294 in 2004 to 17,867 in 2005. http://www.irs.gov/newsroom/article/0,,id=150358,00.html
Who is being classified?
Employers must report the incomes of employees and independent contractors using the IRS form W-2 and 1099, respectively. Employers pay different taxTax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
es (i.e. Social Security
Social Security (United States)
In the United States, Social Security refers to the federal Old-Age, Survivors, and Disability Insurance program.The original Social Security Act and the current version of the Act, as amended encompass several social welfare and social insurance programs...
and Medicare
Medicare (United States)
Medicare is a social insurance program administered by the United States government, providing health insurance coverage to people who are aged 65 and over; to those who are under 65 and are permanently physically disabled or who have a congenital physical disability; or to those who meet other...
taxes, unemployment tax
Federal Unemployment Tax Act
The Federal Unemployment Tax Act is a United States federal law that imposes a federal employer tax used to help fund state workforce agencies. Employers report this tax by filing an annual Form 940 with the Internal Revenue Service...
es, etc.) on the wages of a worker that is classified as an employee. However, these same taxes are generally not paid by the employer on the compensation of a worker classified as an independent contractor. If an employer intentionally or mistakenly classifies an employee as an independent contractor, the employer is then at risk for being heavily fined and paying back-taxes.
Being classified as an independent contractor also affects whether an employee can receive unemployment benefits. In many states, independent contractors are not eligible for unemployment benefits because nothing has been paid into the unemployment insurance fund on their behalf. Employers who have no W-2 employees are not required to make payments to the unemployment insurance fund, and since no one can file a claim for benefits, they don't have to worry about their accounts being charged any extra. So should a misclassified employee lose his job through no fault of his own, that employee has no recourse with the Department of Labor and no unemployment benefits upon which to fall back.
Construction workers are often the most misclassified workers in the industry of the United States, Europe, and the Middle East. Workers are misclassified for the employers to reap a different benefit, such as paying fewer taxes and paying less benefit, and workers are paid incorrectly. Organizations fighting against this fraud are shown below.
Employee vs. independent contractor
According to the IRS, an employee is anyone who performs services for an employer if the employer can control what will be done and how it will be done. This was codified in revenue ruling 87-41, and is generally called "the twenty factor test". http://www.ncarts.edu/formsprocedures/IRS.htmhttp://www.irs.gov/pub/irs-pdf/p15a.pdfhttp://www.irs.gov/businesses/small/article/0,,id=99921,00.html Independent contractors are defined so if the payer or employer has the right to control or direct only the result of the work done, and not the means and methods of accomplishing the result. There are also other categories such as non-employees, which include direct sellers.http://www.irs.gov/charities/article/0,,id=128602,00.htmlMitigating IRS reclassification risk
One must determine if an evaluation of a worker’s classification is necessary. Independent contractors on an approved vendorVendor (supply chain)
A vendor, or a supplier, is a supply chain management term meaning anyone who provides goods or services to a company. A vendor often manufactures inventoriable items, and sells those items to a customer.- History :...
list, or whose services are on an exempt services list, may not require an evaluation. Also, independent contractors immediately willing to become W-2 employees through a Portable Employer of Record will not require an evaluation.
If the analysis is necessary, a qualified Compliance Officer attempts to produce an accurate judgment of the workers classification, and delivers his or her written recommendation to the employer.
A Compliance File, including all necessary supporting documentation for the compliant independent contractor, is kept on file in the event of an audit
Audit
The general definition of an audit is an evaluation of a person, organization, system, process, enterprise, project or product. The term most commonly refers to audits in accounting, but similar concepts also exist in project management, quality management, and energy conservation.- Accounting...
.
External links and resources
- "Independent Contractors vs. Employees", irs.gov
- "IRS Offers Tips on How to Correct Reporting of Misclassified Employees", irs.gov, March 27, 2006
- "Avoiding IRS reclassification of workers as employees.", Tracy A. Freeman, The Tax Adviser, February 1 1996
- "FedEx Drivers Fight for ‘Employee’ Status, Rights", Megan Tady, The NewStandard, July 18, 2006
- "Sebelius Announces Campaign to Ensure Fairness for Kansas Workers and Businesses", infozine.com, July 11, 2006
- "Waxman: Blackwater may have evaded millions in taxes", Justine Redman, CNN, October 23, 2007