Independent Contractors: The Consequences of Reclassification
The Internal Revenue Service has identified the employee-independent contractor reclassification issue as a significant compliance challenge. Reclassification can be particularly devastating to small businesses, resulting in tax assessments, penalties and interest charges so large that bankruptcy is the only alternative. Because it is so costly, business owners and their CPAs must be aware of the tax and other consequences before making any decision to change. In 1988, the IRS began a nationwide employment tax examination program (ETEP) to increase compliance by requiring businesses to treat misclassified independent contractors as employees subject to withholding taxes. Employers classifying workers as employees must withhold federal income and Social Security taxes (including Medicare) from employees' pay and match the Social Security and Medicare taxes. Employers also are subject to federal unemployment tax (FUTA) and various state employment taxes. Between October 1987 and December 1991, the General Accounting Office reported that 6,900 ETEP audits resulted in $468 million of proposed assessments and reclassification of 338,000 workers as employees. RELIEF? In some cases, taxpayers can obtain relief from reclassification by taking advantage of Internal Revenue Code section 530 (see the sidebar on page 48), which absolves employers of prior employment tax liability if they meet certain safe haven requirements. (For more on the use of section 530, see JofA, Dec. 92, page 63.) While companies are not obligated to withhold income taxes or pay employment taxes when they meet section 530's requirements, the IRS frequently uses the section as a bargaining tool, agreeing to its applicability only if a business reclassifies workers prospectively. Faced with costly legal battles most small businesses can't afford, many have accepted the IRS offer. Reclassification of a worker from independent contractor to employee for federal purposes is likely to cause a similar reclassification for state tax purposes. Since many states do not have retroactive relief provisions like section 530, they might try to assess employment-related taxes. In addition, numerous federal laws (such as the Age Discrimination Employment Act of 1967, the Occupational Safety and Health Act of 1970 (OSHA), the Employee Retirement Income Security Act of 1974 (ERISA), the Emergency Planning and Community Right to Know Act of 1986, the Americans with Disabilities Act of 1990 (ADA) and the Family Medical Leave Act of 1993) impose compliance costs on businesses when the number of employees exceeds certain thresholds. Other consequences of reclassification include nondiscrimination and coverage requirements in pension and profit-sharing plans and workers' compensation rules. STATE TAX CONSEQUENCES State laws differ in their definitions of "employee." However, many states refer to the IRC or to federal income tax provisions or indirectly adopt the federal definition by referring to common law rules focusing on an employer's right to control an employee's work. A few states (including Arkansas, Iowa and Mississippi) have their own definitions of employee: typically a person who performs services for another and receives wages. EMPLOYEE MANDATES AND THRESHOLDS Some small businesses cannot afford the administrative and compliance costs of programs like OSHA and the ADA. Paperwork and complexity have led them to avoid hiring new employees and to grow by using independent contractors or by requiring current employees to work excessive overtime. Among the most burdensome laws with low thresholds is OSHA, which applies to companies with 11 or more employees or the ADA, which applies to those with 15 or more. Businesses often describe OSHA as a regulatory nightmare. ADA compliance is far more burdensome than compliance with similar state laws. While the ADA's legislative history and purpose suggest "employee" be defined broadly, there remains an incentive for companies to classify workers as independent contractors to avoid falling under its jurisdiction (see "ADA Compliance: Let Uncle Sam Help," JofA, Sept. …