Employee or Independent Contractor? Classifying Workers Incorrectly Could Prove Costly

Independent Contractor & Payroll ProcessingThe Internal Revenue Service, in partnership with the U.S. Department of Labor and various state labor departments, continues to strongly enforce regulations meant to prevent misclassification of employees as independent contractors (ICs). Fortunately, an amnesty program is now in place that will allow an employer who has misclassified workers as ICs to bring them onto the employee payroll and avoid some of the federal penalties that would normally be incurred.

A crackdown on labor misclassification began in the middle of the last decade, partly because of the continually growing percentage of U.S. workers who were being hired as contractors instead of employees. Real and perceived abuses of led the IRS to hire a task force of another 100 agents earlier this year to investigate cases of worker misclassification. The estimated $25 million cost of stepping up enforcement is a drop in the bucket compared to the billions in formerly unpaid payroll taxes the government expects to bring in.

Businesses, of course, have many incentives – financial and otherwise – to hire some of their workforce as ICs instead of bringing them on as employees. Employers do not have to pay Social Security, Medicare or unemployment taxes on contractors, or offer them the same health insurance and other benefits that employees are eligible for. But the use of contractors also makes the workforce more flexible since hiring and firing them involves less paperwork and creates less risk of lawsuits based on alleged discrimination or other violations of labor laws. Payroll administration is simplified, too, because payments to ICs are simply reported on 1099 forms rather than going through the payroll processing system.

Needless to say, all of these advantages are lost – and then some – when the IRS makes a determination that a contractor actually fits the legal definition of an employee. Penalties and remedies for misclassification can include:

  • back payment of income taxes
  • back payment of payroll taxes (including what would normally have been the workers’ portion of Social Security taxes)
  • back pay to workers for unreimbursed overtime, sick leave or holidays
  • back payment of premiums to the company’s insurance provider
  • reimbursement to workers for medical expenses that the company’s insurance would have covered, had they been properly classified as employees

The Voluntary Classification Settlement Program (VCSP) announced by the IRS in September offers the possibility of greatly reduced federal back payments and penalties for qualifying employers who apply for the program, meet certain criteria and agree to certain stipulations. For example, businesses who want to voluntarily reclassify some of their ICs as employees must have filed all required 1099 forms for the last three years. They must also be willing to agree to leave the next three years’ taxes open to IRS audit for 6 years instead of the usual 3 years.

It’s important to remember that the VCSP is a federal program. Many states have enacted their own legislation on this issue in recent years, and the VCSP does not deflect any penalties or sanctions at the state level. California’s new misclassification law is particularly harsh, raising the maximum state fine for misclassifying a worker from $5,000 to $25,000.

Even small business payroll can be complicated, but it’s a lot simpler when you hire the experts at Padgett Payroll Services. Call 877-244-5842 today to find out more about the benefits of letting us take care of your company’s payroll management.

Payroll Tax Cut Extended for at Least Two More Months

Social Security Payroll Tax Cut ExtensionThe payroll tax cut that was in effect for 2011 was extended for another two months by a Congressional vote that took place just before Christmas. The employee share of the Social Security tax would have jumped from 4.2 percent back up to its pre-2011 rate of 6.2 percent on December 31 if federal lawmakers had not been able to reach a temporary compromise. Uncertainty remains among political analysts and payroll specialists alike as to whether the tax cut will be extended once again through the remainder of this year.

Because of the eleventh-hour nature of the compromise, some payroll administration systems may have been programmed to resume withholding from employees at the 6.2 percent rate. In these cases, the IRS advises payroll managers that they have until Jan.31 to implement the correct rate. Amounts over-withheld in January must then be paid back to employees no later than March. 31.

The continuation of the 2 percentage point reduction in the tax will result in about $83 more in monthly take-home pay in January and February for a worker earning at a rate of $50,000 annually. In 2011, the lower rate put a total of $1,000 more in such a worker’s pocket.

Highly paid employees – those who earn more than $18,350 in the first two months of the year – may eventually have to “repay” a portion of the 2 percent difference as part of their 2012 income tax liability. For those employees, a special 2 percent income tax will be levied against their January-February earnings in excess of $18,350, thus offsetting the Social Security tax savings on that portion of their income. This special 2 percent “clawback” or “recapture” tax won’t be payable until 2012 income taxes become due in 2013, and will likely be eliminated altogether if the Social Security tax cut is eventually extended through the remainder of this year.

An earlier version of the two-month extension compromise bill provided for the same effect to be accomplished through two-tiered tax withholding – a rate 4.2 percent up to $18,350, and 6.2 percent beyond that. Because of the difficulties that payroll processors would have faced in implementing such a complex withholding structure in such a short time, the National Payroll Reporting Consortium opposed this plan in a Dec. 11 letter to Congress.

Dealing with frequent changes to payroll taxes and the continual uncertainty in payroll laws can be difficult and distracting for a small business owner. Payroll outsourcing to the experts at Padgett Payroll Services relieves employers of the worry and burden of keeping up to date with these changes. Call Padgett today at 877-244-5842 to find out more about how we can help simplify the job of running your business.