Reducing Exposure for Independent Contractor Misclassification

Federal and state agencies continue to crackdown on employers who misclassify “employees” as “independent contractors.” Employers can realize significant cost savings when they classify workers as independent contractors as opposed to employees. Independent contractors are not entitled to overtime compensation and businesses avoid employment taxes and costs associated with unemployment and workers’ compensation coverage requirements. These savings sometimes lead employers to be overly aggressive when classifying workers. However, the penalties for misclassifying employees as independent contractors can be costly, including payment of back taxes and hefty fines.

What to do when you think you have misclassified.  The first step is determining whether the worker in question is in fact improperly classified as an independent contractor. Counsel should be retained to review the various tests used to determine if the classification is appropriate. If the worker has been misclassified, the next step is to determine whether the employer can take advantage of one of the available “safe harbors” to reduce exposure for the misclassification. The “safe harbor” providing the most protection is contained in Section 530 of the Revenue Act of 1978.  Under this section, if an employer has a reasonable basis for classifying workers as independent contractors, the employer may be relieved from the tax liability if it can demonstrate: 

  1. it reasonably relied on a judicial precedent, technical advice, prior government audit, long-standing recognized practice in the industry or had some other reasonable basis to classify the workers as independent contractors;
  2. it consistently treated the workers in question as nonemployees for employment tax purposes; and
  3. it filed all necessary tax returns (e.g., Form 1099).

If the employer can satisfy these criteria, it may avoid IRS employment tax liability despite misclassifying independent contractors.  Employers should be aware that Section 530 is limited to federal employment taxes and does not reach any applicable state and local employment taxes.

For more information about Section 530 safe harbors and employee versus independent contractor classification, please contact John R. Vreeland, Director of the firm’s Wage & Hour Compliance Practice Group, jvreeland@nullgenovaburns.com, or Douglas J. Klein, dklein@nullgenovaburns.com.