Worker Classification and Employment Taxes

During the 1990s, after corporate restructurings resulted in vastly reduced work forces, companies often found themselves in short supply of workers when business picked up. Reluctant to hire full-time employees in case of a downturn, they turned to a "contingent work force." Some examples of contingent workers are leased employees, temporary employees, outsourced employees, part-time employees and independent contractors.

A common misconception is that all contingent workers are classified as independent contractors for employment tax purposes. This misconception has persisted despite the fact that contingent workers work for long periods of time and with the company's regular employees.

Section 530 of the Revenue Act of 1978, the 20-factor test of Rev. Rul. 87-41 and the IRS's recent focus on the level of control that an employer has over a worker are some of the methods the Service uses in determining a worker's status as an employee or independent contractor.

An agreement between company and worker on the worker's status is not binding on the IRS. Misclassification of a worker as an independent contractor can be costly to a business.

Employment Taxes

Regular method. A company can face substantial tax deficiencies if, as a result of a Service employment tax audit, an IRS agent reclassifies workers from independent contractors to employees. These deficiencies include:

1. Employer's share of FICA/Medi-care tax (7.65%);

2. Employee's share of FICA/Medi-care tax (7.65%);

3. Federal income tax withholding (28%);

4. FUTA (usually a low rate);

5. Failure-to-deposit penalty (10% and 15%), under Sec. 6656;

6. Failure to file a return or pay tax (up to 25%), under Sec. 6651; and

7. Interest on deficiencies, under Sec. 6601.

An employer can seek a math credit from the Service for self-employment and income taxes paid by a worker. However, ascertaining the amounts paid by the worker can be a burdensome process. The usual method of substantiating the math credit is to obtain copies of Form 1040 from workers.

Sec. 3509 method. Relief under Sec. 3509 may be the best approach for an employer. As a prerequisite to using Sec. 3509, an employer must establish that it did not intentionally disregard the law when it treated a worker as an independent contractor. Under Sec. 3509, the lowest tax liability is the employer's share of FICA, plus 20% of the employee's share of FICA, plus Federal income tax withholding at 1.5%.

Although the assessment under Sec. 3509 is reduced, the employer cannot assert the math credit or seek reimbursement from the worker. As with an assessment under the regular method, Secs. 6651 and 6656 penalties can apply.

The Sec. 3509 percentages can be increased to 40% of the employee's share of FICA and 3% Federal income tax withholding if, without reasonable cause, the employer failed to file Forms 1099.

The Sec. 3509 method has potentially significant benefits.

Example: The IRS makes an assessment for calendar year 2001 for a worker with earnings of $80,400 (using the Social Security OASDI taxable wage base of $80,400). Under the Sec. 3509 method, the employer's FICA and Federal income tax withholding liability is $8,586.72, as follows:

Under the regular method, the employer's FICA and Federal income tax withholding liability is $34,813.20 (FUTA tax (which is typically low) is ignored).

Conclusion

There is no reason to expect a slowdown in job growth for contingent workers. Companies should look into the tax and legal implications of contingent workers. If a Service audit results in an employment tax assessment, the company should be aware of its potential liability.

From Barbara Josefowicz, J.D., LL.M., New York, NY