The High Cost Of Worker Misclassification: Tax Implications And Risks
The consequences of misclassifying an employee as an independent contractor can be costly. You could be liable for back taxes (including the employee’s shares of unpaid payroll and income taxes), penalties and interest. There may be serious nontax consequences as well.
How important is this?
Businesses must withhold federal and state income taxes and the employee’s share of Social Security and Medicare taxes from employee wages. They must also pay the employer’s portion of Social Security, Medicare and unemployment taxes for employees. Generally, none of these obligations apply to the business for workers who are independent contractors.
Misclassifying an employee as an independent contractor can result in liability for unpaid payroll taxes, penalties and interest. You may also owe the employee’s share of taxes.
Beyond taxes, misclassification can mean liability for minimum wages, overtime pay, benefits, workers’ compensation, and state disability insurance. Ensuring proper classification helps avoid costly legal and financial consequences.
What factors should you consider?
Determining the correct classification requires reviewing the key factors that the IRS evaluates. No single factor is conclusive; all must be taken into account.
Here are the three categories of factors the IRS assesses:
1. Behavior control. Who controls what work is done and how it’s performed? A higher degree of control suggests the worker is likely an employee. It’s important to consider how much training and education the business provides a worker to do the job.
2. Financial control. Who controls the economic aspects, such as how the worker is paid and how expenses are reimbursed? Independent contractors generally have financial risk. They may work for flat fees and work for more than one business.
3. Type of relationship. Workers hired for an indefinite period and performing core business functions are more likely to be employees.
Labeling a worker as an independent contractor in a written contract doesn’t make it so. However, it may serve as evidence in a dispute between parties.
How does remote work affect classification?
It’s tempting to think that if a person works for you remotely, he or she automatically qualifies as an independent contractor. Not so fast! Even if the individual chooses to work remotely, the classification is still subject to scrutiny.
The key considerations are the same as for on-site workers, such as whether you, as the business owner, have the right to control the details of the worker’s services and how they’re performed.
Worried you’ll make a mistake?
Don’t underestimate the importance of this issue. The consequences of misclassification can indeed be severe. Using a reasonable basis for classifying workers may relieve penalties and employment taxes.
You can ask the IRS to weigh in by filing Form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” Before you do this, contact the office and ask for a review of the details.
Beyond federal taxes
Even if you’re confident in your classification of workers for federal tax purposes, it’s essential to consider how they’re treated under state taxation and federal and state wage and hour regulations. Classifying workers as employees in some cases and independent contractors in others can create significant administrative challenges, so evaluate their status comprehensively before making a final decision. Don’t risk a mistake. Answers to your questions are a phone call away.
Your Return Is Filed! 3 Things To Keep In Mind Post-filing
Most people feel some relief after filing their income tax returns each year. But even if you’ve successfully filed your 2024 return, you may still have questions. Here are three common ones.
1. What’s the status of your refund?
You can learn the status of your tax refund using an IRS online tool. Go to irs.gov and click on “Get Your Refund Status.”
You’ll need your Social Security number, filing status and refund amount.
2. What if you forgot to report something?
In general, you can file an amended tax return and claim a refund within three years after you filed your original return or within two years of the date you paid the tax, whichever is later. So, if you filed your 2024 tax return on April 15, 2025 (the due date for 2024 returns), and barring any changes in the rules, you’ll generally have until April 18, 2028 (because April 15 is a Saturday and April 17 is a holiday in Washington, DC) to amend your return.
However, there are a few situations when you’re allowed more time to file an amended return. One example is claiming a bad debt deduction. Generally, you may amend your tax return to claim a bad debt for seven years from the tax return’s due date for the year the debt became worthless.
3. How long must you keep tax records?
Retain tax records as long as the IRS can audit your return or assess additional taxes. The statute of limitations is generally three years after filing, meaning most 2021 tax year records can now be discarded if you filed by the April deadline in 2022. If you filed an extension, keep records from the extended due date for three years.
The statute extends to six years for substantial underreporting (over 25% of gross income). There’s no time limit if you never filed or filed fraudulently. So, keep actual tax returns indefinitely to prove legitimate filing.
Retirement account records should be kept until the account is depleted, plus three (or six) years. Real estate and investment records should be kept for as long as you own the asset, plus at least three years after selling, or six years to be extra cautious.
Being diligent with recordkeeping can help you avoid IRS issues down the line.
Still have questions?
Contact the office for help finding answers about your refund, filing an amended return or record retention.
