Several recent news items highlight the importance of properly classifying workers for tax purposes as either independent contractors or employees. This is a complex issue that confronts many businesses across a wide array of industries.
Blackwater Security Consulting has come under Congressional scrutiny recently due to its classification of security guards as independent contractors rather than employees. Rep. Henry A. Waxman D-Cali., Chairman of the House Committee on Oversight and Government Reform, sent a letter late last month to Blackwater owner Erik Prince in which he referenced possible tax evasion regarding Blackwater's federal tax classification of its security guards stationed in Iraq as independent contractors rather than employees. The letter noted the fact that earlier this year the IRS ruled that Blackwater should have classified a security guard as an employee rather than an independent contractor, after the security guard had protested his classification as an independent contractor. Blackwater apparently at least partially relied on the Small Business Administration's classification of the company's security guards as non-employees, but this situation reinforces the point that a classification determination by an agency other than the IRS does not control the proper tax classification. Similarly, an independent contractor classification for tax purposes does not automatically preclude individuals from suing employers under statutes that protect employees, but not contractors, from discrimination.
Not long after the Blackwater issue came to light, the IRS released two items relating to the enforcement of proper classification of workers. First, the IRS issued a new form (Form 8919) that provides for individuals to report their employee share of uncollected federal taxes resulting from a misclassification by an employer of the individual as an independent contractor rather than an employee. Next, the IRS revealed a fact sheet detailing its new "Questionable Employment Tax Practice Initiative" designed to share information with state agencies in order to increase employment tax compliance at both the federal and state levels.
Form 8919 must be filed by an individual if he or she performed services for a business, the business did not withhold the proper federal taxes, and certain other conditions apply that indicate the individual was an employee of the business rather than an independent contractor. Typically, misclassifications are discovered during IRS or state unemployment tax audits or when an independent contractor mistakenly applies for unemployment benefits or workers compensation. The availability of Form 8919 gives the IRS an additional tool for finding and challenging alleged misclassifications, as well as giving workers an easy way of challenging a disputed classification.
As for the Questionable Employment Tax Practice Initiative cited above, 29 states have signed a memorandum of understanding with the IRS and other federal agencies (including the Department of Labor) in order to participate in the program. The Questionable Employment Tax Practice Initiative will allow the participating federal and state agencies to exchange audit reports and audit plans and even participate in side-by-side examinations of businesses in order to discover classification problems.
Whether or not a service provider is an employee or independent contractor for tax purposes is a factual determination based on each particular situation and the label applied by the hiring business is not determinative. The process that should be applied in making a determination of the proper classification can be very complicated and usually involves the application of various factors to each worker's situation. The main issue is whether or not the business exercises a sufficient amount of control over the service provider so that he or she should be considered an employee of the business. Similar rules apply to determinations of employment status under state and federal employment discrimination laws, although those standards vary depending on the jurisdiction.
If a service provider is an employee, the business must withhold federal income and payroll taxes and pay the worker's share of FICA taxes on the wages plus FUTA tax. There can also be state tax obligations on the business as well as other consequences (e.g., the provision of fringe benefits). On the other hand, if a service provider is an independent contractor, then the business is not responsible for paying any taxes on such services and only has to send a Form 1099-MISC showing the amount paid by the business to the service provider for the year.
The consequences of a tax misclassification can result in severe financial penalties and often threaten the survival of a business. The IRS, however, has several programs that an employer might be able to use for relief without such disastrous consequences. A business must also be cognizant of state tax laws regarding worker classification, which may impose a different standard than the federal rules. In any event, if a business classifies workers as independent contractors that would typically be or could be considered employees, it should consult its tax counsel to evaluate the classification and potential risk.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
