Payroll Tax Issues

Avoiding Employment Penalties for Misclassification of Employees

Dec 29, 2021

Introduction: The Dangers of Putting Your Company at Risk by Misclassifying Employees

More and more companies are turning to the gig economy. This system saves businesses the hassle of hiring full-time employees, but it also poses a great risk. The biggest risk is misclassifying employees as independent contractors in order to avoid paying the benefits given to regular employees. The following section will discuss how this can happen and what risks companies face when they do not comply with labor laws in regards to misclassification.

What Does the Law Say about Employment Classification?

The law has been evolving to meet the needs of a changing workforce. In this section, we will take a look at the classification of employment and how it affects an employee’s legal rights.

The law is in constant flux when it comes to defining what an “employee” is. This term includes any person who works for another for wages or salary. There are various types of employees, including full-time employees, temporary employees, and independent contractors. This article will provide a brief overview of these different types of employment relationships in order to help you know which one best suits your needs.

Why is Employment Classification so Important in the U.S.?

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Employment classification is the first step to ensuring that the employees are classified as per their contribution to the company. The classification helps in paying different taxes for different classifications of employees. It is important because it provides an insight into how much an employee should be taxed, what benefits they are eligible for, and what other benefits are available to them.

The US has guidelines for determining the employment classification which differs from state to state. It includes three major categories: statutory employees, common-law employees, and independent contractor/self-employed workers.

It is important to understand how each category of employment affects each individual's tax liability and benefits under federal law.

To avoid penalties for classifying employees as independent contractors you need to know the three legal tests: the economic realities test, the control test, and the risk test.

What can happen if you have employees erroneously classified as independent contractors?

The IRS has made it clear that an employer-employee relationship exists when the employer has the right to control or direct the worker; however, there are many issues that can arise when there is a misclassification.

If you have employees erroneously classified as independent contractors, here are some of the things that can happen:

The Internal Revenue Service may find out about it and assess penalties if they deem you to be willfully misclassifying your employees. You could also be fined for not providing full-time work, not paying overtime wages, and more, depending on the number of infractions and severity of your violation.

IRS Voluntary Classification Settlement Program

The Voluntary Classification Settlement Program (VCSP) is a settlement program that is open to employers who, for tax years starting in 2013, were members of the IRS Large Business and International (LB&I) Division’s Large and Mid-Size Business (LMSB) Self-Assessment Program.

The VCSP allows employers to voluntarily correct their employment tax classification for one or more workers, without penalty. Specifically, to be eligible for the VCSP, a taxpayer must:

  1. Want to voluntarily reclassify certain workers as employees for federal income tax withholding, Federal Insurance Contributions Act (FICA), and Federal Unemployment Tax Act (FUTA) taxes (collectively, federal employment taxes) for future tax periods;
  2. Be presently treating the workers as non-employees;
  3. Have filed all required Forms 1099 for each of the workers to be reclassified for the 3 preceding calendar years ending before the date Form 8952 is filed (a taxpayer will meet this requirement if it filed all required Forms 1099 for the workers being reclassified for the period of time that the workers worked for the taxpayer; for example, a taxpayer who has only been in business for 2 years meets this requirement if the taxpayer filed all required Forms 1099 for the workers being reclassified for those 2 years);
  4. Have consistently treated the workers as non-employees;
  5. Have no current dispute with the IRS as to whether the workers are non-employees or employees for federal employment tax purposes;
  6. Not be under employment tax examination by the IRS (if the taxpayer is a member of an affiliated group, this requirement is met only if no member of the affiliated group is under employment tax examination by the IRS);
  7. Not be under examination by the Department of Labor or any state agency concerning the proper classification of the class or classes of workers; and
  8. a. Not have been examined previously by the IRS or the Department of Labor concerning the proper classification of the class or classes of workers; or b. If the taxpayer has been examined previously by the IRS or the Department of Labor concerning the proper classification of the class or classes of workers, the taxpayer must have complied with the results of the prior examination and not be currently contesting the classification in court.

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