Employer’s Liability When a Worker Is Misclassified
When a worker is unintentionally misclassified as an independent by an employer, the employer is often liable for certain back taxes and fees.
Generally, fees are assessed as follows: 1.5% of the wages paid to the employee and 20% of the employee’s share of FICA that should have been imposed (IRC Sec. 3509). If no 1099s were filed for the worker, the penalty is 3% of wages and 40% of employee’s FICA. The employer isn’t entitled to recover these amounts from the employee. Of course, the employer is still liable for his/her own share of the FICA and for FUTA taxes.
Penalties and interest for failure to deduct and withhold may also be assessed. The penalties are based on the amount of the employer’s liability determined under Code Section 3509. If an employer misclassifies an independent contractor without reasonable cause, the following could apply:
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The employer can be held liable for employment taxes. However, the employer’s FICA tax liability can be reduced by the amount of SE tax paid by the employees., This relief does not affect the employer’s liability for penalties and additional tax. (CCA 201808016),
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The late tax deposit penalty could apply., The penalty is 2% of the underpayment if the deposit is not more than 5 days late; 5% if more than 5 but not more than 15 days late; 10% if more than 15 days late.
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If a deposit is made within 10 days of the taxpayer receiving a demand notice, the penalty is 15% of the underpayment.
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A 100% penalty (plus interest) can be imposed on persons responsible for withholding, accounting for or depositing withholding taxes. This penalty is often referred to as the Trust Fund Recovery Penalty.
In addition to penalties and additional tax liability for employment taxes, employer-maintained retirement and benefit plans (e.g., group health insurance, cafeteria, educational assistance plans, etc.) may be adversely affected when a worker has been misclassified. In the extreme case, the IRS could disqualify a retirement plan for failing to properly cover all workers in accordance with the terms of the plan if a worker who had been treated as an independent contractor is found really to be an employee. Or the plan could fail certain non-discrimination and participation tests when the reclassified worker’s compensation is included. Disqualification of such plans would impact both the employer (who would not be allowed to deduct the costs associated with the retirement or benefit plans) and other employees who were participants in the plans.
Interest Free Payroll Withholding Adjustment
In a Chief Counsel Advice (CCA-201109025) dealing with the issue of worker misclassification, IRS has provided guidance on the time frame for paying prior period federal income tax withholding and FICA taxes without incurring any interest charges.
Generally, interest must be paid to IRS on any underpayment of tax. However, Reg. § 31.6205-1(a) allows certain FICA or withholding tax underpayments from previous periods to be corrected on an interest-free basis if the employer files an amended return in the 94X series (e.g., 941-X, 944-X) to report the error, and the taxes are paid in full by the last day for filing the employment tax return for the quarter in which the error is “ascertained.” The employer is required to enter the date the error was “discovered” on the “94X” form, and to provide in detail the grounds and facts relied on to support the correction.
The date the error was “discovered” is also provided on Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. Employers and workers may submit Form SS-8 to IRS to receive a determination regarding an employee's worker status (i.e., employee or independent contractor).
In the CCA, IRS notes that the SS-8 determination letter will provide the date that the error was “discovered,” but the standard used in Reg. § 31.6205-1(a) for interest-free adjustments is the date when the error was “ascertained.” IRS says that an error is “ascertained” when the employer has sufficient information to correct it. The SS-8 determination letter will not always control the “ascertained” date (e.g., the employer may need to determine which employees are similarly situated and/or go through its records to obtain information to fill out Form 941-X), though some employers may have sufficient information at that point to determine the “ascertained” date. IRS notes that, in all cases, the employer must be able to prove when the error was ascertained for purposes of making an interest-free adjustment.
Note: No interest-free adjustments may be made for an underpayment after the employer has received a statement of notice and demand for payment of the underpayment based on an assessment (Reg. §31.6205-1(a)(6)). Interest free adjustments also are not allowed after the employer receives from the IRS a Notice of Determination Concerning Worker Classification under Code Sec. 7436.