Misclassification of Worker IRS Penalties

By | March 7, 2015

As we have seen, the status of a worker as either an independent contractor or an employee must be determined accurately in order to ensure that workers and businesses can anticipate and meet their tax responsibilities. Businesses decide whether to hire employees or independent contractors depending on individual needs, customer expectations, and worker availability. Either worker classification – independent contractor or employee – can be a valid and appropriate business choice. Whatever the choice, the classification of a worker must be correct and this is something that the IRS takes seriously.


Work Classification Challenges by IRS

The majority of classifications of workers are not challenged by the IRS. However, when IRS reclassifications are made, it can result in the assessment of significant employment tax liabilities. Congress recognized this in 1978 and passed Section 530 of the Revenue Act of 1978. Section 530 provides businesses with relief from federal employment tax obligations if certain requirements are met. It terminates the business’s, but not the worker’s, liability for the following employment taxes: federal income tax withholding, Social Security and Medicare taxes (FICA), and Federal Unemployment Tax (FUTA). It also means the business is not required to pay any interest or penalties resulting from the liability for employment taxes.

Information on Section 530 relief can be found in Publication 1976 (PDF), titled Section 530 Relief Requirements. This publication is on the IRS Web site.


Section 530 Relief Requirements for Worker Classification

Now let’s take a few minutes to address the application of Section 530 of the Revenue Act of 1978. In certain circumstances, Section 530 can relieve businesses of employment tax liability resulting from worker misclassification, but the business must meet specific requirements under the law.

The business must meet the following three requirements to receive relief under Section 530:

  • Reporting consistency
  • Substantive consistency, and
  • Reasonable basis

The business must meet ALL three tests.  Meeting these three tests means that the business will not owe employment taxes for the workers in question. If these tests are not met by an employer, there could be special taxes owed.


IRS consistency tests

The business must demonstrate two types of consistency:

  1. First, the business must treat all workers in similar positions the same. This is called substantive consistency. The business (and any predecessor business) must not have treated the workers, or any similar workers, as employees. If you treated similar workers as employees, this relief provision is not available. In other words, treatment of the workers must be consistent with the position that they were not employees. For example, if the business treated a worker as an independent contractor, it must treat all workers in a similar position as independent contractors. Let’s say a business employed 20 workers performing the same duties under the same direction and control, and treated 15 as employees and 5 as independent contractors. In this scenario, the substantive consistency test would not be met.
  2. Second, the business must file all required federal tax returns on a consistent basis. This is called reporting consistency. This means that if a business believes a particular worker or group of workers are properly classified as independent contractors, then the business must demonstrate to the IRS that they have been filing the required forms – for example, Form 1099-MISC – for those independent contractors.

Relief is not available for any year the business did not file the required Forms 1099-MISC. If they filed the required Forms 1099-MISC for some workers, but not for others, relief is only available for the workers for whom the 1099-MISC was filed.


Section 530 – Reasonable Basis

In addition to meeting both consistency tests, the business must also have a reasonable basis for not treating the workers as employees. To establish that you had a reasonable basis for not treating the workers as employees, you can show that:

  • You reasonably relied on a court case about federal taxes or a ruling issued to you by the IRS; or
  • Your employment tax liabilities were audited by the IRS at a time when you treated similar workers as independent contractors and we did not reclassify those workers as employees; or
  • You treated the workers as independent contractors because you knew that was how a significant segment of your industry treated similar workers; or
  • You relied on some other reasonable basis. For example, you relied on the written advice of a business lawyer or accountant who knew the facts about your business.


What happens if worker is classified?

It is the position of the IRS that the judicial precedent relied upon must have been in existence at the time you made the decision to treat the workers as independent contractors. Additionally, if you are relying on industry practice, you will need to show that you knew, at the time you began treating your workers as independent contractors, that this was the industry practice – for example, a survey of the industry prior to your treatment.

If you did not have a reasonable basis for treating the workers as independent contractors, you do not meet the relief requirements.