We live in an evolving world where modern businesses are looking for new ways to complete tasks and meet company objectives. This often includes hiring workers from different backgrounds and in different categories to better satisfy the needs of your organization. But, these varying employee types create additional risks for businesses.
Misclassifying an employee can trigger an IRS audit, leaving businesses liable for unpaid income taxes and steep fines. For businesses in Washington, failing to classify workers correctly could result in significant financial fines and penalties which is especially dangerous for small businesses. It’s critical to address this issue before it creates bigger problems.
What Are the Potential Penalties for Misclassifying Employees?
The penalties can be steep when businesses misclassify employees as independent contractors. Employers are often required to pay back taxes, additional penalties, and interest on unpaid amounts. The IRS may also take legal action beyond what you already owe after an audit takes place. Misclassified workers often miss out on tax benefits, such as the earned income tax credit, further complicating matters for the employer.
If a misclassification is deemed unintentional, several penalties may still apply. These include a $50 fine for each unfiled Form W-2 and a fine of 1.5% of the employee’s wages, along with a fine of 40% of unpaid FICA taxes. Employers must also pay their full share of FICA taxes. Interest accumulates on these amounts from the original due date, and a failure-to-pay penalty of 0.5% per month, up to 25% of the total tax liability, is also imposed.
More serious consequences arise if the IRS suspects intentional fraud. In those cases, employers face an additional 20% penalty on wages and must pay 100% of the FICA taxes, covering both employer and employee portions. Criminal fines may also be levied, up to $1,000 per misclassified worker, and in extreme cases, employers could face imprisonment. Misclassified employees can also sue for back wages and other penalties.
The reputational damage that comes from being found guilty of employee misclassification can be just as costly as the fines. A business that faces legal battles and bad press risks losing the ability to attract and retain talent.
Getting Employee Classifications Right is Critical
While it may seem straightforward, distinguishing between W-2 employees and 1099 contractors can be tricky. However, several tests can help businesses determine how to classify workers.
The IRS common-law test evaluates three areas: behavioral control, financial control, and the relationship between the employer and worker. Key questions include whether the company controls how the work is performed, whether the company covers expenses or provides necessary tools, and how permanent the working relationship is. For employers who remain uncertain, IRS Form SS-8 can be filed to request an official determination of a worker’s status.
The Department of Labor’s Economic Reality Test, updated in 2024, also helps distinguish between employees and contractors under the Fair Labor Standards Act (FLSA). This test focuses on factors such as the opportunity for profit or loss based on managerial skill, the degree of permanence in the working relationship, and how integral the work is to the employer’s business. If the work is key to the business’s success, the worker is likely an employee rather than a contractor.
Another tool is the reasonable basis test, which reviews past IRS or court rulings on similar workers. If, for example, a previous IRS audit found that workers in similar positions weren’t employees, this may support a reasonable basis for classifying a worker as a contractor.
Get Out of Trouble with the IRS
If you’re concerned about employee misclassification, the time to act is now—not when the IRS finds out. The IRS takes these cases seriously, but with the right legal advice, you can avoid severe penalties. Contact Robert V. Boeshaar, Attorney at Law, or schedule a consultation today to discuss how to resolve these and other tax-related issues.
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