01/07/2020
This is a recent article that I wrote about Employee Misclassification. Very hot topic with the IRS right now.
EMPLOYEE CLASSIF**ATION – WHAT TO EXPECT WHEN THE STATE OF CALIFORNIA IS THROUGH WITH YOU AND THE IRS TAKES OVER
Last month’s Mirror contained a very informative article by Shane Clary about California Assembly Bill 5, which adds some statutory clarity to employee vs. independent contractor relationships in California. As Shane mentioned the bill codifies a decision from the California Supreme Court in Dynamex Operations West v. Superior Court (2018) 4 Cal. 5th 903 (the Dynamex case). If you haven’t read Shane’s article go back and read it, because if you own, or work in any capacity, for an Alarm company, it may very well affect you.
While the State of California has made employee classification a priority, there is another, more powerful group out there waiting to take their bite of the apple. The Internal Revenue Service estimates that 30% of employees may be misclassified as independent contractors. This means that hundreds of millions of dollars of Income Tax, Social Security, and Medicare payments may not be paid in in a given year. This is low hanging fruit and the IRS intends to pick it.
Although the IRS tests for employee/contractor relationships are similar to the ABC tests that Shane mentions in his article, the IRS considers all information that provides degree of control and independence when evaluating the relationship. Additionally, the IRS particularly focuses on one element of the relationship, that is the B of the ABC test … “that the worker performs work that is outside the usual course of the hiring entity’s business.” This is the test that shoots down most independent contractor assertions. If the hiring entity already knows how to perform the work (i.e. installing an alarm panel), then why would they need to contract this function out? This test is typically applied, and failed, when the relationship is between a hiring company and an individual. AB 5 defines contractors that are truly businesses, and, contracting businesses that meet the requirements of the Bill may avoid scrutiny from the IRS.
But what about the individual that you contract to do an install in Blythe? You don’t have an office there, you don’t normally install alarms there, so you hire a “contractor” to put the system in. The “contractor” works at other times for a licensed company, has a State Registration, and does the installation piecemeal. While this may conceivably fit the definition of AB 5, it will most probably not fly with the IRS. The IRS has established a task force, based in Oklahoma City, with hundreds of Revenue Agents and Officers, who are actively scanning tax returns for this type of situation.
Let’s say you hired this guy as an independent contractor and, somehow, the State of California is cool with it. That should cover you with the IRS, right? Well, not exactly, if you pay this person $600 in a calendar year, you are required to issue them a 1099. If the “contractor” doesn’t have a business tax ID number (i.e. he/she is using their Social Security Number) our friends in Oklahoma may be alerted to the fact that you are making payments to individuals who may, in fact, be employees. Just as many State investigations are triggered by a “contractor” who files for unemployment or workers’ compensation benefits, workers who believe that they may have been misclassified for Federal purposes may file Form SS 8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Witholding. This form may be filed for a number of reasons, for example, one of the requirements to claim the Child Care Credit is that the Taxpayer have earned income from employment. Self employment income (from, say, being a ‘contractor’) doesn’t count. Many ‘contractors’ who find themselves missing out on a $4,000 plus tax credit may be advised by their friendly neighborhood tax preparer to file the form, especially when they also realize that they owe $6,000 plus of Self Employment Tax on their $20 an hour ‘contracting’ income. This is when things can get bad. The IRS leans on the ‘contractor’ for income tax and self-employment taxes (Social Security) and the ‘contractor’s’ recollection of the relationship undercomes a drastic metamorphosis. The ‘contractor’ suddenly remembers that they were an employee. They can then file Form 8919, Uncollected Social Security and Medicare Tax on Wages to figure and report their share of uncollected Social Security and Medicare taxes due on their compensation. If a Form 8919 is filed, our Friends in Oklahoma City will most definitely get involved.
If the IRS opens an investigation and determines that the ‘contractor’ is in fact an employee what can happen?
• A $50 penalty for each form W-2 that the employer failed to file because of classifying employees as independent contractors.
• Since the employer failed to withhold income taxes, it faces penalties of 1.4% of the wages, plus 40% of the F**A taxes that were not withheld from the employee’s wages and 100% of the matching F**A taxes the employer should have paid. Interest is also accrued on those penalties daily from the date that the amounts should have been deposited.
• A Failure to Pay Taxes penalty equal to 5% of the unpaid tax liability can be imposed and for up to 25% of the total tax liability.
• If the IRS suspects fraud or intentional misconduct, it can impose additional fines and penalties. For instance you would be subject to penalties that include 20% of all of the wages paid, olus 100% of the F**A taxes (both employer and employee). Criminal penalties of up to $1,000 per misclassified worker and one year in prison can be imposed as well.
And, just to rub salt in the wound, since many of the above amounts are penalties, they aren’t deductible from income tax.
If you still want to wade into the Contract Employee pool remember that you swim at your own risk.
Mitch Reitman is the Managing Principal of Reitman Consulting Group. He is a CAA Associate Member, winner of the 2007 Mark Schubert CAA Associate of the Year Award, and is a member of the Electronic Security Industry Hall of Fame.
