The consequences of misclassifying workers can be costly. If you misclassify an employee as an independent contractor, for example, you may be liable for back taxes (including the employee’s shares of unpaid payroll and income taxes), plus penalties and interest. 

Our business tax pros highlight the importance of properly classifying employees, including serious nontax consequences, how to determine what’s suitable for your business needs and more in these FAQs.

Why does worker classification matter?

Businesses must withhold federal and state income taxes, Social Security taxes and Medicare taxes from the wages they pay employees and deposit those taxes with the IRS or state tax authorities. They’re also required to pay the employer’s portion of Social Security and Medicare taxes, and to pay federal and state unemployment taxes. Generally, none of these obligations apply to independent contractors.

What happens if you misclassify an employee as an independent contractor? 

Not only will you be liable for the employer’s portion of payroll taxes that you should have paid (plus penalties and interest), but you also may be on the hook for the employee’s portion of income and payroll taxes.

There may be significant nontax consequences as well. For example, when classified as an employee, the worker may be entitled to minimum wages and other employee benefits. And you may need to furnish workers’ compensation insurance and make state disability insurance contributions.

How do you decide how to classify workers?

To decide whether workers are employees or independent contractors for federal tax purposes, familiarize yourself with the factors the IRS considers in making that determination. Many of these factors go to the degree of control the business exerts over the worker and the degree of independence the worker enjoys. No single factor is determinative, so it’s important to weigh all of them. 

The IRS examines factors in three categories:

1. Behavioral control. Does the company control or have the right to control what the worker does and how the worker does it? Generally, the more control the company has, the more likely a worker is an employee. Relevant factors include the extent to which the company provides instruction and training.

2. Financial control. Does the company control the business aspects of the worker’s job, such as how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies? A worker is more likely to be considered an independent contractor if, for example, he or she has an opportunity for profit or loss, makes his or her services available to other businesses, or is paid a flat fee rather than an hourly wage.

3. Relationship of the parties. Workers are more likely employees if the company provides them with employee benefits, they’re hired indefinitely (rather than for a specific time period or project) and they provide services that are a key aspect of the business.

Note, entering a contract with a worker that designates him or her an independent contractor doesn’t make it so. However, it may be a relevant piece of evidence in determining the parties’ relationship. 

A common misconception among businesses is that all remote workers are independent contractors. The ability to work remotely may demonstrate a worker’s independence. But a remote worker may still be considered an employee if the business controls the details of the work that’s done and how it’s performed.

What are my options if I need to reclassify some workers? 

The IRS does offer an optional Voluntary Classification Settlement Program that provides businesses with an opportunity to reclassify their workers as employees for future employment tax purposes. This program offers partial relief from federal employment taxes for eligible businesses who agree to prospectively treat their workers as employees. Businesses must meet certain eligibility requirements and apply by filing Form 8952, Application for Voluntary Classification Settlement Program (VCSP), and enter into a closing agreement with the IRS.

If you are audited for worker misclassification, there are a couple of other settlement options to consider: 

• Classification Settlement Program (CSP). This allows businesses to resolve employment tax worker classification issues early in the examination process. Under the CSP, examining agents may be required to offer worker classification settlements to taxpayers. If a taxpayer accepts the settlement offer, the agreement is finalized by the parties entering into a standardized CSP closing agreement. However, before offering a settlement, agents must first determine whether the taxpayer satisfies the three requirements of Section 530. Under both programs, the taxpayer's employment tax liability for prior years is reduced in exchange for agreeing to reclassify workers.
• Early Referral to Appeals Program. Businesses under audit also have the option of requesting that developed and contested employment tax issues be referred to the IRS Appeals under the Early Referral to Appeals Program. If the request is accepted, the employment tax issue is resolved at Appeals while other issues under examination continue to be developed in examination or collection.

Are there any nontax consequences to consider?

Even if you’re comfortable with your classification of workers for federal tax purposes, it’s important to consider their treatment for other purposes, such as state taxation and federal and state wage and hour regulations. Treating workers as employees for some purposes and independent contractors for others can pose a significant administrative burden, so examine their status for all purposes before making your final decision.

Here to Guide You

Classifying workers as independent contractors can generate significant cost savings. But given the potentially harsh consequences of misclassification, it’s critical to have a reasonable basis for your classification. If you do, and you meet certain other requirements, you may be entitled to relief from penalties and from having to pay the worker’s employment taxes.

If you’re unsure whether a worker or group of workers should be classified as employees or independent contractors, reach out to a trusted tax advisor, like those at Doeren Mayhew, for guidance. Our business tax pros are here to explain the rules in more detail to help you make an informed decision and avoid costly penalties.