IRS is looking for mis-classified workers

What happens if an employer misclassified a worker as an independent contractor and doesn't withhold income taxes or FICA? Does that mean the person is not liable for the taxes? One Florida woman found out the hard way that the answer is "no."

She worked as a seamstress at a retail bridal gown shop. The shop classified the woman as an independent contractor and paid her $11,210 during the year in question. The shop did not withhold income or employment taxes from its payments to her. The seamstress also received unemployment compensation of $208 that year from the Florida Agency for Workforce Innovation.

The woman also failed to file a tax return for the year. So the IRS filed one for her as a self-employed person with its "Substitute for Return Program" and sent her a tax bill. Later, the IRS agreed that the seamstress was an employee, rather than an independent contractor. The woman contended that the bridal shop, which failed to withhold taxes from her wages, was solely liable for the tax bill.

The Tax Court stated that it was "unfortunate" the employer classified the seamstress as an independent contractor and not as an employee.

But, the court added, "that does not alter the fact that the first principle of income taxation is that income must be taxed to (the person) who earns it" and "misclassification of an employee does not relieve the employee of his liability for filing a correct tax return." (Natalia Ravelo Escandon, TC Memo 2007-128)

In some cases, workers can sue for benefits they claim they were eligible for, including health insurance and retirement plan contributions.

To make matters worse, the IRS continues cracking down on companies that hire independent contractors. If the tax agency "reclassifies" a worker as an employee, your company could be slapped with hefty bills for back taxes, interest and penalties. Audits by state agencies are also common and frequently occur when independent contractors apply for unemployment or Workers' Compensation.

Unfortunately, no single factor determines a worker's status. In the trucking company case described above, the Tax Court looked at these seven questions:

1. What degree of control is exercised by the business? Under this test, the court examined how much control the company exerted over the way the services were performed. But exercising control is not required in an employer-employee relationship, the Tax Court noted, as long as the company has the right to direct a worker if necessary.

2. Which party invests in "work facilities," used by the individual? "The fact that a worker provides his or her own tools generally indicates a non-employee status," the Tax Court explained.

3. Does the individual take any financial risk? "A worker's opportunity to earn a profit and assume risk of loss may indicate a non-employee status," the Court stated.
4. Can the business discharge the individual? "Generally, an employer's right to discharge an employee indicates an employer-employee relationship," the Tax Court noted.

5. Is the work an integral part of the company's regular business? An employer-employee relationship is supported when workers perform a service essential to the success of a business operation.

6. How permanent is the relationship? The Tax Court stated that "a transitory work relationship may point toward a non-employee status."

7. What kind of relationship do the parties believe they are creating? Entering into a written agreement that states a worker is an independent contractor indicates a non-employee relationship. However, a contract alone is not enough. "If an employer-employee relationship exists, characterization by the parties as some other relationship is immaterial," according to the Tax Court.