Can Businesses Face Tax Penalties for Worker Misclassification?

 Posted on January 04, 2024 in Employment Taxes

Worker classification is a common issue that affects businesses across many different industries. Although treating workers as independent contractors may provide some benefits for employers, incorrectly classifying employees as independent contractors can result in serious legal and financial consequences. Employers who are concerned about potential tax penalties related to worker misclassification may want to consult with an attorney to determine what steps they can take to protect themselves.

Determining Employee vs. Independent Contractor Status

The distinction between employees and independent contractors is crucial, because it can affect whether an employer will be required to provide certain benefits to workers, and it can also determine how taxes will be applied to the compensation a worker receives. The Internal Revenue Service (IRS) provides guidelines to help determine how a worker should be classified:

• Behavioral control: If the business has the right to control what work will be done and how it will be performed, including instructions on when, where, or what tools to use, the worker is likely an employee.

• Financial control: If the business controls aspects such as payment methods or reimbursable expenses, provides tools or materials needed for the job, or invests in facilities used by the worker, that suggests an employer/employee relationship.

• Type of relationship: Consideration should be given to any written contracts specifying whether benefits are provided (such as vacation pay or health insurance), the permanency of the relationship, and whether the work a person performs is a key aspect of the employer’s business.

The Consequences of Worker Misclassification

Misclassifying workers can lead to financial penalties for an employer who failed to withhold and pay payroll taxes. In some cases, an employer may also face potential lawsuits filed by aggrieved workers who may seek unpaid wages, benefits, and other types of compensation. Some of the penalties that can affect an employer who has misclassified workers may include:

• Payroll taxes: When workers are misclassified as independent contractors, the business is not required to withhold income taxes or pay Social Security and Medicare taxes on their behalf. However, if the IRS determines that misclassification has occurred, the business may be liable for retroactive payroll taxes, plus penalties and interest.

• Unemployment insurance: State unemployment insurance programs typically require employers to contribute funds based on a percentage of their employees' wages. Misclassifying workers can result in unpaid contributions and potential fines.

• Workers' compensation insurance: Businesses must provide workers' compensation coverage for employees to protect them in case of work-related injuries or illnesses. Independent contractors are generally not covered under this insurance, but workers who have been misclassified may sue an employer for damages if they are injured while working.

The Voluntary Classification Settlement Program

The IRS offers businesses an opportunity to correct worker classification mistakes through the Voluntary Classification Settlement Program (VCSP). This program provides certain tax relief measures as long as specific eligibility requirements are met:

• The business must have consistently treated its workers as independent contractors before applying.

• The business cannot currently be under audit by the IRS regarding employment tax issues.

• The business must agree prospectively to treat the workers in question as employees in future tax years.

• The employer must pay 10% of any employment tax liability that would have been due for compensation paid to those workers for the most recent year.

If an employer is approved to participate in the VCSP, they will not be required to pay any penalties or interest on the amount of employment tax liability for the previous year. No further audits related to worker classification for previous years will be conducted.

Contact Our San Jose Tax Attorney

If you are an employer who is uncertain about how to classify workers, or if you believe you may have misclassified employees as independent contractors, it is advisable to consult with an experienced attorney to determine your options for resolving issues related to employment taxes. At John D. Teter Law Offices, our San Jose, CA tax lawyer can help assess your current procedures regarding worker classification, and we can provide guidance on how to address tax-related concerns and avoid or minimize penalties. To learn more about how we can assist with issues related to employment taxes, contact us at 408-866-1810 and schedule a consultation.