If a worker is an employee, rather than an independent contractor, the employer is required, among other things, to withhold and remit the employee’s tax to the federal government. How do you know when the worker is an employee? In general, if the employer controls not only what is to be done but also how it is to be done, then the worker is an employee, and the employer has to withhold.
The Treasury Department prefers to have an employer withhold; the
fewer returns from independent contractors, the better. The fact
is, however, that more and more employees are joining the ranks of
independent contractors. Some do this voluntarily, but for most, it
is a result of the downsizing going on in corporate America.
Corporations, on the other hand, having downsized for financial
reasons, are hesitant to hire someone as a permanent employee unless
it is absolutely necessary. And so, when new projects require an
increase in workforce, they hire independent contractors.
The result is that companies are hiring workers for specific projects
and sometimes incorrectly classifying them as independent
contractors, thus incorrectly leaving the withholding up to them.
Why does this misclassification happen? That is a question we will
consider later in this article. At this point, let us consider
some of the penalties that employers are subject to as a result of
One of the worst consequences of incorrectly classifying workers as
independent contractors is found in the case of Vizcaino v.
Microsoft, 97 F.3d 1187 (9th Cir. 1996), reh’g en banc 120 F.3d 1006
(9th Cir. 1997), discussed in our March issue (#643). In that case,
the misclassified workers won, among other things, the right to
participate in Microsoft’s employee stock purchase plan.
Even where options to purchase stock are not at stake, however,
misclassification of workers can prove costly to employers. The
Internal Revenue Service (IRS) has a whole arsenal of civil and
criminal penalties that it can impose upon employers, whether the
misclassification is merely negligent or willful. Some, but not all,
of these penalties are listed below.
Failure to withhold income taxes. The
employer is subject to the penalty of 1.5 percent of wages paid,
plus interest compounded daily.
Failure to withhold FICA (Social Security) taxes. The employer is subject to the penalty of 20 percent of the FICA tax on the employee, plus interest compounded daily.
Failure to report workers’ wages or other payments on Forms W-2 or
1099-MISC. The employer is subject to the penalty of 3 percent of
wages paid and 40 percent of the FICA tax.
Willful Failures Failure to file tax return relating to
employment taxes. The employer is subject to the penalty of paying
the employer share of Social Security and unemployment taxes, as
well as a penalty equal to 5 percent of the tax for each month of
the failure to pay, up to a maximum of 25 percent of the tax.
Failure to pay employment taxes. The employer is subject to
the penalty of 0.5 percent of the tax, for each month of the
failure to pay, up to a maximum of 25 percent of the tax.
Understatement of Employment Taxes
The employer who, either negligently or willfully, understates its
liability for Social Security and unemployment taxes is subject to
the penalty of 20 percent of the understatement.
Fraudulent Understatement of Employment Taxes
The employer who fraudulently understates its liability for Social
Security and unemployment taxes is subject to the penalty of 75
percent of the understatement.
Criminal Penalties Willful failure to collect and remit
withholding taxes and the employee portion of FICA taxes. Each such
failure is a felony that, on conviction, results in a fine up to
$10,000 or imprisonment up to five years, or both.
20 Questions and Three Main Categories
The Internal Revenue Service (IRS) considers20 factors in determining
whether a worker is an employee or an independent contractor.
HR.BLR.com/Compensation. It should also be noted that the IRS
revised the manual that its auditors use in analyzing worker
classification issues. The manual notes that "because of the
difficulty in applying the 20-factor test and because business
trends have changed over the years, the Service has recently begun
using a new approach with respect to worker classification.
Rather than listing items of evidence under the 20 factors, the
approach now is to group the items of evidence into the following
three main categories: behavioral control, financial control, and
the relationship of the parties."
This may not be all that helpful, but it does show that the IRS
recognizes that "business trends have changed over the years," and
now more and more independent contractors are being hired. One of
the IRS’s 20 factors is whether there is a continuing relationship
between the company and the worker. With respect to this, the
Manual states that "a long-term relationship may exist between a
business and either an independent contractor or an employee."
A New Approach
Why do employers misclassify employees as
independent contractors? There are, of course, the willful
misclassifications, done deliberately to save money. For instance,
there probably have been cases where companies knowingly treated
workers as employees and yet represented to these workers, and to the world, that they were independent contractors. To any employers who contemplate such a charade, we can only say that they run the risk of severe civil and even criminal penalties.
How can we explain the unintentional misclassifications? If a
company knowingly hires independent contractors, how does it happen
that, after a few years, the IRS conducts an audit, and the company
is shocked to learn that the independent contractors are, under
common law standards, employees?
An answer is suggested by a recent article entitled "New Mentality
Required for Corporations Hiring Independent Contractors," (The
Journal of Taxation of Employee Benefits, Jan/Feb 2000). The author,
Jeffrey Rodriguez, tells companies that, to avoid problems with IRS,
they have to develop a new mindset; they have to stop feeling the
old corporate need to exercise direct control over the independent
This suggests a misclassification scenario. The company starts out
intending to treat its independent contractors as such, but it does
not have the requisite "new mentality" described by Rodriguez. It
may have intended at the outset to simply tell the workers what it
wants them to do and to leave them alone to do it, but then the
corporate need to control manifests itself. As time passes by, the
company begins to exercise more and more control over the way in
which the workers perform the job.
One day, without realizing it, the company is, in effect, treating
the workers as employees and thus running the risk of IRS penalties
for not withholding, among others. Well, at least that’s one
The New Mindset
Rodriguez suggests that, with respect to
the 20 factors used by the IRS to determine whether workers are
employees, the company should try to modify its behavior as well as
its mentality. For instance, one of the factors indicating an
employer-employee relationship is whether the employer gives the worker lots of training. Rodriguez suggests the following:
"[T]o the maximum extent possible, Company X should retain workers who require little or no training. If training is necessary, it should require workers to obtain training at their own expense. If the training is only available from Company X, it should charge workers for the training at the same rate that it would charge any unrelated entity. Workers should not be trained by having an experienced employee work with them or by requiring attendance at meetings. Periodic training or training at frequent intervals should be avoided.…"
Then again, maybe it really would make more sense just to hire these people as full-time employees. Only kidding.
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This article reprinted with permission by the publisher Business and Legal Reports, Copyright 2000, BLR.