Federal Employment Tax Issues You Need to Know When Engaging Independent Contractors

At a glance

• The main takeaway: If your business leverages independent contractors, it’s important that you understand the federal, state, and local employment tax regulations and legal risks that can come from the misclassification of workers.
• The impact on your business: Engaging independent contractors can come with significant operational benefits, however, misclassification of workers can put your business at risk of costly tax liabilities and penalties.
• Next steps: Aprio’s Employment Tax Services team can review your independent contractor classifications to help you remain compliant with both federal and state regulations. 

Schedule a consultation today to learn more.

The full story:

Engaging 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 and must factor in both initial terms and ongoing management. The decision also becomes important in the context of the M&A space when an organization that is being acquired utilizes significant numbers of ICs, and post-acquisition when decisions need to be made as to future positioning of the workforce.

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 the governmental agency that reviews the contractor relationship. Due to these inconsistencies, worker classification for IRS federal employment tax purposes 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 layers of potential risk to the organization. In fact, the Internal Revenue Code does not provide a specific definition of employee versus 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 ICs. Misclassification can lead to significant tax liabilities, penalties, and other issues in the legal and benefits space. For federal employment tax purposes:

• 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, and Social Security and Medicare taxes from the employee’s wages.
• Independent Contractors: ICs are, by definition, considered self-employed 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 IC or an employee by focusing on:

• Behavioral control of the worker by the business,
• Financial control of the worker by the business, and
• The contractual and control relationship between the parties.

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

• Does the IC have an independent business that they operate with multiple clients, or does their livelihood depend on one business client and are 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 workers are ultimately found to have been misclassified as ICs by the IRS, there can be significant tax liabilities (as of now) for employers, generally pursuant to Internal Revenue Code Section 3509:

• Back Taxes: If the IRS determines that a worker was misclassified as an IC, the business may be required to pay back taxes that should have been withheld and paid, including federal income tax, Social Security, and Medicare taxes if the company failed to report the ICs compensation on form 1099 NEC, Nonemployee Compensation. 
• Penalties: In addition to back taxes, businesses may face penalties for failure to properly classify workers as employees, such as:
  • Federal Income Tax penalty equivalent to 1.5% of reclassified wages.
  • Social Security tax due in the amount of 1) the employee share of taxes (6.2%) and 2) 20% of the employer share of taxable wages (1.24%)
  • Medicare tax due in the amount of 1) the employee share of taxes (1.45%) and 2) 20% of the employer share of Medicare taxable wages (.29%)
• Reclassified workers must be considered employees from the audit period forward, 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 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 to their analysis and position with respect to the engagement if ICs, focusing on what is called the Economic Reality Test. It is important to note that numerous legal challenges are currently being mounted challenging 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:
  • 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, and
  • Skill and initiative.

In the event 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.

Best practices for compliance

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

• Conduct a Worker Classification Audit: Regularly review the status of all workers to ensure they are correctly classified based on 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 have approved all new IC arrangements before engaging for services. Consider both federal and state laws in the space and consider going beyond a simple checklist for approvals.  Reviewing the nature of the proposed services, the background of the IC, and the proposed relationship of the parties are all important factors to consider.
• Use Written Agreements: Clearly define the terms of the relationship with ICs 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 be clear in their language.
• Stay Informed: Keep up with changes in tax laws and regulations regarding worker classification, especially in certain states and with respect to federal differences in the treatment of ICs. The legal landscape is constantly evolving, particularly with the growth of the gig economy. 
• Consult with Tax/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.

• 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 these three factors are met to the IRS’s 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 the 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 of employment tax that would have been due in the most recently closed tax year, with no additional interest or penalty assessed. Also, the agreement would bar the IRS from future audits of the taxpayer on worker classification issues.

The bottom line

Engaging ICs is a business decision that comes with significant federal, state, and local employment tax and legal risk if not properly analyzed and maintained. Proper classification of workers, understanding tax reporting requirements, and staying compliant with both federal and state regulations are crucial 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.