The IRS has significantly increased its employment tax enforcement efforts, and employers who are misclassifying their workers as independent contractors could face significant penalties.
By IRS definition, misclassification is the practice of designating an employee as a "1099 worker," or an independent contractor, when, by law, that person should be compensated as an employee. A misclassification can result in potentially significant civil penalties. Further, if the misclassification is determined to be intentional, the employer may face criminal prosecution.
Intentional misclassification may be done in an attempt to avoid payroll taxes, unemployment taxes and workers' compensation insurance. In the construction industry, this practice may also allow a company to submit lower bids for projects and undercut ethical contractors who are following the letter of the law.
IRS increases tax enforcement efforts
IRS Commissioner John Koskinen recently announced the agency will hire 600 to 700 more enforcement employees in an effort to increase its audit rate. The announcement sparked some debate as to how these new resources should be utilized, and leaders in the construction industry called for increased enforcement of worker classification.
"Employee misclassification allows a company to undercut ethical contractors who are following the letter of the law."
This urging is in line with the IRS' recent initiative to reduce the tax gap – the annual shortfall between taxes owed and taxes paid. The IRS estimates employers who misclassify employees as independent contractors are costing the government billions of dollars a year in lost income taxes. In fact, employment taxes have been identified by the IRS and other federal agencies as contributing $54 billion to the approximate $290 billion tax gap. Further, IRS reports have found millions of workers are being misclassified as independent contractors. Accordingly, the classification of workers as either employees or independent contractors is gaining attention.
Whether a worker is deemed an independent contractor or employee is fundamental to the Internal Revenue Code. Roughly 60 percent of all federal tax revenue comes through the employment tax system. When taxes are withheld from an employee, compliance rates are generally at their highest. Compliance rates are reduced (even when Forms 1099 are filed) where no withholding is required.
The IRS recently released Fact Sheet 2015-21 to provide employers with additional guidance on properly determining whether workers should be classified as employees or independent contractors. Proper classification of workers can be a difficult task for businesses; however, in the current environment of increased enforcement, employers are advised to review this Fact Sheet or speak with their CPAs to ensure compliance and avoid civil and criminal penalties.
Businesses needing further guidance or clarification on employee tax classification should contact a member of the Construction Industry Group at LaPorte.