Independent contracting has increased in popularity lately due to the potential flexibility and freedom it provides both the employers and the contractor. There are some businesses that prefer to only work with 1099 contractors, due to some of the complexities and higher costs of hiring W-2 employees. Employees can cost up to 30 percent more to hire than independent contractors due to the employer’s legal requirement to match Social Security, unemployment insurance, liability insurance, and more.
Many modern businesses run with less overhead and prefer working mainly or exclusively with 1099 contractors. If a business hires only 1099 workers it does not mean that laws have been broken. If all of a company’s workers pass the common-law test for an independent contractor then there should be no issues of legality. The IRS provides form SS-8 to make the determination for employers who aren’t sure.
Employees are protected by federal and state laws that are designed to protect workers from unsafe or unfair workplace environments, however independent contractors are generally not protected by these same laws. There are some unscrupulous employers that purposely classify their employees as independent contractors in order to save money on taxes or minimize overhead. These businesses risk substantial penalties if they are audited. Regardless of the reduced tax burden and administrative costs of hiring an employee, an employer should never misclassify a worker as an independent contractor.
It is estimated that 20% of businesses misclassify some of their employees as independent contractors. One study by the US Treasury estimated that approximately $70 billion is lost annually due to employee misclassification. Some of this misclassification is due to ignorance of employment law and the IRS 20 factor test. However some of it is intentional tax evasion.
Whether a misclassification is intentional or unintentional, there are significant penalties for misclassification. In the cases where an employer was honestly mistaken, and filed 1099 forms on time for the misclassified employees, the penalty is 1.5% of the employee’s wages, 20% of the amount that should have been withheld from the employee, and 100% of the employer’s share. If the mistake was unintentional and 1099 forms were not filed, the penalty of 1.5% and 20% is doubled. Intentional misclassification has an even more severe penalty, and additional fines may be included.
The IRS offers a 20 factor test to help businesses classify their workers. Due to the variety of different employment circumstances, these rules may not fully clarify the status of a worker. If there is further confusion after this 20 factor test, then Form SS-8 should be filled out by the employer. This form is used to request a worker’s status by the IRS. A determination from the IRS may take up to 6 months.
Once a determination has been made by the IRS, it is much safer to use that determination for tax purposes. If a worker is classified as a 1099 contractor and the IRS suspects that there was a misclassification for some reason, they may audit the company. This is because the IRS heavily relies on revenue from tax withholding. Thus, it is much safer to file form SS-8 if there is any doubt whatsoever, and rely on the IRS’s response for tax purposes.
