Federal Employment Tax Issues When Engaging Independent Contractors

At a glance

• The main takeaway: Engaging with independent contractors involves significant tax and legal risks when not properly managed.
• Impact on your business: Proper worker classification, understanding tax reporting, and compliance with regulations can help businesses leveraging independent contractors avoid costly mistakes.
• Next steps: Follow best practices and seek professional advice to navigate payroll tax issues with independent contractors. Aprio can help you manage payroll and employment taxes to keep your business compliant.

Schedule a consultation with Aprio’s Employment Tax Services team today.

The full story:

Independent Contractors (ICs) can offer businesses flexibility, specialized skills, and cost savings. However, navigating the payroll tax implications of using ICs instead of or in addition to employees is a critical management decision, from drafting out the initial terms to ongoing management. In the context of the M&A space, the position also becomes important when the organization being acquired utilizes significant numbers of ICs, and when decisions need to be made as to future positioning of the workforce post-acquisition.

It is important to note that the definition and criteria utilized to define who qualifies and who does not for IC status can vary significantly based upon the tax type or other governmental agency reviewing. That is to say that worker classification for IRS federal employment tax purposes, which is the focus of this article, may not align with such treatment for state employment taxation or U.S. Department of Labor/Fair Labor Standards Act. 

For that reason, it is vital to thoroughly review all IC relationships utilizing multiple lenses, including tax and legal, as there may be several levels and layers of potential risk/exposure to the organization. In fact, the Internal Revenue Code does not provide a specific definition of employee vs. IC relationship, leaving the courts to fill in the gaps over the years, and the IRS to provide processes and procedures to address those gaps for taxpayers.

Classification of Workers for Federal Employment Tax Purposes

One of the most significant issues in the context of payroll taxation is correctly classifying workers as either employees or independent contractors. Misclassification can lead to significant tax liabilities, penalties, and other issues in the legal and benefits space.

• Employees: When a worker is classified as an employee, the employer is responsible for withholding and reporting federal and, where applicable, state/local income and unemployment taxes, as well as social security and Medicare taxes from the employee’s wages.
• Independent Contractors: By definition, independent contractors are considered self-employed individuals, and the business generally does not withhold/remit/report any payroll taxes on the ICs compensation. Instead, ICs are responsible for reporting and remitting their own employment taxes.

The IRS generally uses a three-prong test to determine if a worker is an independent contractor or an employee, focusing on:

• The behavioral control of the worker by the business
• The financial control of the worker by the business
• The contractual and control relationship between the parties

The test can be highly subjective and is based on an accumulation of factors. Overall, the IRS impetus in the employment tax space is the degree of overall direction and control that the business exerts over the worker’s business activities. Consider questions such as:

• Does the IC have an independent business that they operate with multiple clients, or does their livelihood depend on one business client and operating as an individual? (i.e. being reported through their social security number, rather than a federal employer identification number)
• Does the business provide direction and control to the IC as to how to do the job they were engaged for?
• Does the business provide materials to the IC to perform their services at no cost? (e.g. laptops, office space, admin support, etc.)
• Is the IC required to adhere to specific requirements set by the business? (e.g. hours of work, sales quotas, regular reporting, etc.)
• Does the IC receive any benefits that are typically employee benefits? (e.g. car allowance, health benefits, compensation for time not worked, etc.)
• Are there employees of the business performing substantially similar services as ICs?
• Are there significant contractual limitations put on the IC, such as the inability to perform their services for other companies or to market their services without penalty?
• Is the individual designated as an IC a corporate officer of the organization?
  • A corporate officer is considered an employee of the organization they are an officer of, therefore requiring employment tax compliance.

Employment Tax Liabilities

In the event that workers are ultimately found to have been misclassified as independent contractors by the IRS, there can be significant tax liabilities for (now) employers, generally:

• Back Taxes: If the IRS determines that a worker was misclassified as an independent contractor, the business may be required to pay back taxes that should have been withheld and paid, including federal income tax, and Social Security and Medicare taxes, if the company failed to report the ICs’ compensation on form 1099 NEC, Nonemployee Compensation. 
• If the business timely and accurately reported compensation to workers on Form 1099 NEC, then reduced tax and penalties are generally imposed, pursuant to Internal Revenue Code Section 3509
  • Federal Income Tax penalty equivalent to 1.5% of reclassified wages
  • Social Security tax due in the amount of:
    • The employee share of taxes (6.2%)
    • a penalty of 20% of the employer share of taxable wages (1.24%)
  • Medicare tax due in the amount of:
    • The employee share of taxes (1.45%)
    • a penalty of 20% of the employer share of Medicare taxable wages (.29%)

Reclassified workers must be considered employees from the audit period onwards, with all applicable taxes applied.

Other Considerations

State Tax Implications

Beyond federal tax issues, misclassification can also lead to state tax liabilities, including state income tax withholding and unemployment insurance taxes. Each state has its own rules and enforcement mechanisms, so businesses must be aware of both federal and state requirements. 

There are cases where the IC position with respect to Independent Contractor classification differs significantly between federal and state (and even local) treatment.  Some states, such as California, have entirely different classification criteria that should be considered in all IC engagement cases.

Fair Labor Standards Act (FLSA) Governing Minimum Wage and Overtime Pay

In 2024, the U.S. Department of Labor issued new regulations with respect to their analysis and position in the engagement of ICs, focusing on what is called the Economic Reality Test. It is important to note that numerous legal challenges are currently being mounted against the legality of this rule and the DOL’s ability to promulgate such a rule.

This test, as it was enacted via regulation, relies on several factors in its review of the employer/employee relationship, and weighs some factors more heavily than others, including:

• Opportunity for profit or loss depending on managerial skill
  • Investments by the worker and the employer
  • Permanence of the work relationship
  • Nature and degree of control
  • Whether the work performed is integral to the employer’s business
  • Skill and initiative

In the event that a taxpayer is found to be in violation of the FLSA IC test and have misclassified workers, the business may be liable for back wages, including unpaid overtime, as well as liquidated damages and attorneys’ fees.

Leading Practices for Compliance

To mitigate the risk of payroll tax issues related to independent contractors, businesses may want to consider the following in their analysis of their individual independent contractor classification position:

• Conduct a worker classification audit: Regularly review the status of all workers to ensure they are correctly classified based on the IRS and state guidelines. This can help identify potential misclassification issues before they become significant problems.
• New IC engagement: Develop specific policies and procedures to review and approve all new IC arrangements before engaging their services. Consider both federal and state laws and go beyond a simple checklist for approvals. Reviewing the nature of the proposed services, the background of the IC, the proposed relationship of the parties, as well as other factors, are all important points to consider.
• Use written agreements: Clearly define the terms of the relationship with independent contractors in a written contract. While a contract alone does not determine classification, it can help establish the nature of the relationship.  However, such contracts should use clear language to leave minimal room for misinterpretation.
• Stay informed: The legal landscape is constantly evolving, particularly with the growth of the gig economy. Keep up with changes in tax laws and regulations regarding worker classification, especially in certain states and with respect to federal difference in treatment. 
• Consult with trusted tax and/or legal professionals: Given the complexities of payroll tax laws, it is wise to consult with tax professionals or legal counsel to ensure compliance and minimize the risk of misclassification.

Potential Relief and Remediation Opportunities

In the event an IRS audit on worker classification is initiated, or if an organization would like to come forward and voluntarily disclose an IC relationship that now appears to be incorrect (i.e. individual(s) believed to be ICs that should have been employees), relief may be available through the following:

Revenue Act of 1978, Section 530 Relief

Section 530 is a relief provision that addresses a taxpayer’s federal employment tax liability with respect to an individual not treated as an employee if three statutory requirements are met:

1. Reporting consistency
2. Substantive consistency
3. Reasonable basis

Section 530 does not extend to the worker, who may still be liable for the employee share of FICA, not self-employment tax. 

If those three factors are met to the IRS’ satisfaction, workers are not reclassified from ICs to employees and may remain ICs moving forward. Section 530 relief can only be asserted upon IRS examination on a specific worker classification issue.

IRS Voluntary Classification Settlement Program (VCSP)

The VCSP is a voluntary program established by the IRS that allows taxpayers to reclassify their workers as employees for employment tax purposes for future tax periods with partial retroactive relief from federal employment taxes.

To participate in this voluntary program, the taxpayer must meet certain eligibility requirements and apply to participate in the VCSP by filing Form 8952, Application for Voluntary Classification Settlement Program, and enter into a closing agreement with the IRS. 

If accepted into the VCSP and agreed to via closing agreement, the taxpayer agrees to reclassify the noted ICs (either individually or by service type) and pay a penalty based on the past year’s converted compensation, taxed at Section 3509 rates, as noted above. The penalty is 10% of the amount that would have been due, with no additional interest or penalty assessed. In addition, the agreement would bar the IRS from future audits of the taxpayer on worker classification issues.

The bottom line

Engaging with independent contractors is a business decision that comes with significant federal, state, and local employment taxes, as well as legal risks, if not properly analyzed and maintained. Proper classification of workers, understanding tax reporting requirements, and staying compliant with both federal and state regulations are beneficial steps to avoid costly mistakes.

By following leading practices and seeking professional advice, businesses can successfully navigate the payroll tax issues associated with independent contractors. Aprio’s employment and payroll tax consultants can offer you guidance on federal, state, and local employment taxes. Contact our team today.

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