1099 Employee

Testing for Proper Classification of a 1099 Independent Contractor

In the past, IRS used a 20 part test based on common law to determine if a worker was misclassified as a 1099 Independent Contractor. The test is now condensed to three parts, with subparts, focusing on the control of the employee, both financially and behaviorally; and the type of relationship existing between the two parties.

These factors are now set out in Publication 15 A, and are more thoroughly explained on www.IRS.gov under Tax Topic 762, Independent Contractor vs. Employee.

In the event any agency begins an investigation into whether a worker is misclassified, you can attempt to defend your actions by seeking to establish that you had a reasonable basis to believe that the employee was correctly classified as an independent contractor.

The rationale above applies to employment taxes, wages and or workers compensation insurance coverage. An employer must pay the full amount of the premiums for workers compensation coverage for all employees; but not Independent Contractors. So the classification process applies equally to the failure to pay for misclassified employees worker’s compensation coverage as well as taxes and wages.

1099 vs W-2 Investigation Process

• When a complaint arises regarding wages or overtime disputes the employee files a complaint with their state Department of Labor or DOL
• When a claim arises over taxes, an investigation begins. The investigation can be due to past due taxes, incorrect taxes or assessment of self-employment taxes due to issues uncovered during a tax audit, upon the filing of an incorrect return or the complaint of an employee. A claim can also result from an employee filing a complaint or requesting a determination
• For workers’ compensation purposes the trigger is usually the employee is injured on the job and tries to file for worker’s compensation benefits or files a Claims Petition with the SDWC.
• Alternately, any agency involved in a misclassification investigation can refer the issue to the appropriate state agency for worker’s compensation insurance to determine the issue.

A finding from the United States Tax Court, or a Federal agency, that an employee has been misclassified may be considered res judicata by the SDWC in any state and may be introduced into evidence and cause the employer to be collaterally estopped from claiming the worker is an Independent Contractor.

Additionally, many states have a Memorandum of Understanding with the IRS agreeing to work together and share information on misclassified employees and questionable tax practices. If a Memorandum is in place the agency will report the finding to the SDWC so that the facts can be investigated. Cases are often negotiated with each agency to settle the matter at hand. Sometimes the cases are sent to mediation. If you are unable to reach an agreement, the applicable state agency Administrative Law Judge or the Tax Court will determine whether or not the employee is misclassified and whether the misclassification is unintentional, intentional or fraudulent.

Fines, Fees, Penalties and Interest for Misclassification

Even if the appropriate agency or ALJ determines that a misclassification was unintentional, they will still reclassify the contractual amounts paid to an Independent Contractor as wages and then may assess any or all of the following:

• A fine for each W-2 the employer failed to file
• Penalties for failure to withhold income taxes
• Penalties for failure to withhold the Social Security taxes and Medicare taxes
• 100% of the employer taxes that is unpaid
• Additionally there are penalties for failure to pay the taxes, for each month that the taxes are delinquent, up to 25% of the tax due. (Consult the Tax Code for the current penalty rates)
• And finally- interest accrues on all overdue unpaid taxes and penalties

If any agency finds that the misclassification was intentional, fraudulent or criminal; they have the option to assess additional fines, penalties and interest. The agency may refer the case to the appropriate criminal agency to charge the employer with a crime, seek to impose a jail or prison sentence, and additional fines for the criminal act. The owner of the company, a member of a LLC or an officer of a Corporation can all be personally responsible for the unpaid taxes, fines, penalties and interest.

Misclassification for Worker’s Compensation Purposes

In regard to failure to carry Worker’s Compensation Insurance for a worker who has been misclassified; the SDWC in the state where the worker is employed; will similarly determine whether the employee was misclassified as an Independent Contractor. The government agency will make a decision based on similar factors relied on by the IRS. For instance in Vermont the Department of Worker’s Compensation and the Courts have adopted a two part test: The Right to Control and the Nature of Business Test. In contrast, Minnesota uses a nine factor test pursuant to Minn. Statutes, Section181.723 to determine whether an individual is a 1099 Independent Contractor in the construction industry, and a five factor test which focuses on the right to control for other types of individuals not in construction.

Each state has a unique statutory scheme and a set of factors used to determine if an employee is misclassified under the Worker’s Compensation Act in that state. Most states use some part of the factor’s from the common law 20 part IRS test.

In some states, like Wisconsin, field auditors from the Department of Worker’s compensation are authorized to conduct routine worksite compliance investigations and examine employer records without cause.

Many states have an Uninsured Employer’s Guaranty fund which will cover the worker’s injuries and claims for workers who are not covered under a workers’ comp insurance policy. In that event the employer will be assessed the full amount advanced by the fund. Additionally the injured employee now has the right to sue the employer for negligence when there is no workers comp coverage. In very rare cases where the Second Injury Fund is applicable, the fund may contribute where there is no current coverage.

Criminal Acts for Failure to Carry Workers’ Compensation Insurance

Failing to carry workers’ compensation for an employee is a crime in most all states throughout the United States. But the severity of the crime and the accompanying fines, penalties and jail sentence vary from state to state.

The state agency handling worker’s comp usually refers the matter to the district attorney for the county, or the US Department of Justice which handles cases where many workers at one company are misclassified.

In Pennsylvania, the crime is a third degree misdemeanor carrying a $2,500.00 fine and up to 1 year in jail, but if it is intentional, the crime it is a Third Degree Felony carrying a $15,000.00 fine and a jail sentence of up to seven years. Each day that you fail to carry insurance can be charged as a separate crime.

Other states have laws with far stricter penalties. So it is imperative to meet with an attorney licensed in your state if you are criminally charged.

Do 1099 Employees Need Workers' Comp?

If you have any doubt whether or not a worker qualifies as a 1099 Independent contractor you can voluntarily provide workers' compensation coverage as if that person were an employee. If you are a 1099 employee, you can buy a policy or ask the business paying you to provide coverage under their policy.

The company or the worker can file Form SS-8, Determination of a Workers Status for Purposes of the Federal Taxes and Income Tax Withholding with the IRS. All employee/employer taxes should be paid until your company receives a determination on the status.

A company who inadvertently misclassified its workers as 1099 Independent Contractors can enter the IRS Voluntary Reclassification Program. Employers will still be assessed for back wages, interest and penalties; however, the amounts owed for fines, penalties and interest can be drastically reduced. The IRS will allow business owners to enter into an installment plan, and eliminate the risk of IRS proceeding against you criminally as part of the negotiation process.