Employee Or Independent Contractor - Minimizing The Costs Of Misclassification

Monday, July 5, 2010 - 00:00

The Internal Revenue Service (IRS) is actively auditing small business employment practices via employment tax audits and is also conducting an ongoing review of worker classification practices in large employers. Thus, it is important to review who qualifies as an independent contractor and what relief is available to employers who misclassify individuals in their employ.


During a worker classification examination, Section 530 of the Revenue Act of 1978 remains the primary guidance for the IRS to determine proper classification of a worker. If the agent determines that treatment as an independent contractor under Section 530 applies, the agent will close the examination.

Section 530

Generally, to be eligible for relief under Section 530, an employer must have a reasonable basis for treating the worker as an independent contractor and must (according to the IRS) have issued a Form 1099 to that worker. Further, the employer must have treated the worker and all similarly situated workers consistently as independent contractors. Issuing both a Form 1099 and a Form W-2 to the same worker in the same year or alternate years is an automatic red flag in a worker classification examination.

Under Section 530, an employee is a worker who performs services subject to the control of the employer's determination over when and how it is completed. An independent contractor is a worker who performs services using his own means and methods regarding how the work is completed. In order to qualify for Section 530 relief, any of the following four conditions must be met:

1. The employer had a prior employment tax audit in which the IRS either did not challenge the worker classification or found the worker classification proper;

2. The employer obtained earlier IRS guidance on its worker classification such as a private letter ruling (note: such rulings are not currently being issued on worker classification);

3. The employer prevailed in prior litigation regarding worker classification and can rely on the applicable law, or there is a long standing industry practice of treating workers as independent contractors (for example, real estate agents);

4. The employer has any other reasonable basis to treat the worker as an independent contractor.

If the IRS agent determines that the employer may not be eligible for Section 530 relief, the agent will review the following items in making a determination whether classification as an independent contractor is appropriate:

Behavioral control - The IRS will review, among other items, when and where the work is performed as well as what equipment is used (employer provided vs. worker provided);

Financial control - The IRS will review whether the worker provides his/her own equipment/supplies, has unreimbursed expenses, and/or holds his/her services out to the market; and

Relationship of the parties -The IRS will review the contractual relationship between the employer and the worker.

Available Relief For Misclassification

For employers who have unintentionally misclassified workers as independent contractors rather than employees, Internal Revenue Code (Code) Section 3509 provides some relief through reduced tax rates for income tax withholding and FICA contributions on behalf of the misclassified employees. The reduced rates are 1.5 percent of wages as withholding and 20 percent of the employee's share of Social Security to be paid by the employer. It should be noted that these rates are doubled for employers who failed to issue Form 1099 or other required reports under Code Sections 6041(a), 6041A, or 6051 to workers treated as independent contractors.

Under its purely administrative classification settlement program, the IRS has the discretion to further reduce the Code Section 3509 rates. If the employer has been consistently reporting workers as independent contractors, but does not qualify for Section 530 relief by satisfying one of the four reasons noted above, it will pay the above rates on only one year. If the employer has a good argument for a reasonable basis for the classification, the IRS may assess the employer 25 percent of the Section 3509 rates. In both these instances, the employer will be required to execute a closing agreement with the IRS agreeing to treat the workers as employees for all future years.

For employers found to have intentionally misclassified workers, the IRS will typically assess taxes of about 40 percent for each misclassified employee, before any penalties, for the most recent 3 years.


Employers have found treating workers as independent contractors rather than employees to be an effective way to reduce their cost of labor. However, the federal government and many state governments are now very active in reviewing worker classification to ensure that proper tax withholding is occurring and that workers are receiving all benefits to which they are entitled under law. Accordingly, employers need to review carefully their classification of workers to avoid IRS sanctions as well as possible state sanctions.

Peter Alwardt is a Partner with the accounting and advisory firm of Eisner LLP in New York City, www.eisnerllp. com.

Please email the author at palwardt@eisnerllp.com.with questions about this article.