The Classification of Workers in the Era of Tax Reform
Federal and state governments impose a wide array of taxes and other burdens on businesses with employees. As an employer you are required to withhold income, Social Security and Medicare taxes from your workers’ salaries. You pay the employer’s share of these taxes plus federal unemployment and state employment taxes. Left with the choice of paying these taxes or bearing the risks associated with treating employees as independent contractors, many employers opt for the latter. In fact, the IRS once estimated that employers misclassify millions of workers nationally as independent contractors. Some commentators believe the recently enacted Tax Cuts and Jobs Act of 2017 (TCJA) could lead to even more misclassified employees. How big is the employee misclassification problem today, and what is the government currently doing about it?
Generally, an employer/employee relationship exists “when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished.” Treas. Reg. Sec. 31.3121(d)-1(c).
When a worker is misclassified as an independent contractor, the costs to society are considerable. The employee loses federal and state employment protections and benefits. The unlawful business whose taxes are illegally lowered is placed at an unfair advantage over the competition. And the government is deprived of substantial tax revenues. In a 2009 report, the Government Accountability Office estimated in one year alone, the federal government lost out on $2.72 billion in Social Security, unemployment and income taxes because of employee misclassification.
To make matters worse, a new tax deduction in the TCJA could further contribute to employment tax losses. Effective for tax years beginning after Dec. 31, 2017, owners of partnerships, limited liability companies, S corporations, trusts, estates and sole proprietorships are generally entitled to a deduction of 20 percent of the taxpayer’s qualified business income under IRC Sec. 199A. Because Section 199A ties the availability of a deduction to some form of business ownership, some employees may seek to be treated as independent contractors or partial owners for tax purposes.
In an effort to prevent the misclassification of workers, the government employs a multi-faceted approach. The IRS detects misclassified workers primarily through the following sources:
- The Determination of Worker Status (Form SS-8) Program. Under the Form SS-8 program, employers or workers may request that the IRS determine the status of an individual.
- The Employment Tax Examination Program (ETEP). The ETEP allows the IRS to use specific criteria to identify companies likely to have misclassified employees.
- General employment tax examinations. A general examination of an employment return may draw the IRS’s attention to a classification issue.
- The Questionable Employment Tax Practices (QETP) program. Through the QETP, the IRS and states share worker classification-related information.
Over time, the IRS has compiled a list of 20 factors from court decisions to determine worker status. These 20 factors, cited in Rev. Rul. 87-41, have been compressed into three general categories:
- Behavioral control
- Financial control
- The relationship of the parties
No one factor should stand alone in making a determination.
If a company has been found to have misclassified workers, it could be required, at a minimum, to pay 100 percent of the employer’s share of Social Security and Medicare taxes, plus an additional 40 percent on the same obligations and 3 percent of wages under IRC Sec. 3509. Well-intentioned employers that have consistently treated workers as independent contractors may be able to lessen the consequences through the safe harbor of IRC Sec. 530 or the IRS’s Voluntary Classification Settlement Program.
Companies longing to save taxes may want to think twice today before employing a strategy that entails misclassifying employees.
Marcus Dyer, CPA, Esq., is the team leader of tax controversy at Withum. He is a member of the NJCPA Federal Taxation Interest Group and can be reached at email@example.com.
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This article appeared in the November/December 2018 issue of New Jersey CPA magazine. Read the full issue.