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Let's face it: employees are wonderful. We couldn't do without them. However, they can be expensive. Beyond their base compensation, employers must pay federal taxes – in addition to withholding the employee's share of income tax, FICA and Medicare, there is an employer’s share of Medicare and FICA that must deposited regularly. There's also annual FUTA tax, as well as quarterly state unemployment tax. And there are benefits, ranging from medical coverage, to vacations, to sick leave, to name just three, that employers must pay.
When business is down, it is natural to try to find ways to cut operating expenses. Hopefully, you will not be misled by the siren song of those who have an instant solution: "converting" your employees to independent contractors. The pitch sounds great. You issue each person a check every month, without having to worry about withholding, the employer's share of the FICA and Medicare taxes, FUTA, Texas Workforce Commission taxes, etc. Moreover, you don't have to make contributions to any benefit plans, guarantee vacations, etc. Why didn't you think of this sooner?
The answer is simply that it's good that you didn't, and it will be dangerous if you try it. The circumstances governing the status of a worker as an employee versus an independent contractor are beyond the scope of this article, but basically depend on factors involving the extent of behavioral and financial control exerted over the worker. If the people in question are "employees" now, just changing their titles to "contractor" is not going to work a conversion. If they continue to perform the same work on roughly the same terms that have been observed, the IRS and state authorities are not going to accept the hocus pocus of a change of title. What is the downside if you try this and are “caught”?
Well, besides the expense of an audit, the outcome will not be pretty. Under I.R.C. §§ 3101, 3111 and 3402, the IRS is authorized to assess against the employer twenty-five percent (25%) of the compensation paid as income tax withholding, as well as the employee's share of FICA and Medicare taxes, and the employer's share of FICA and Medicare taxes, plus the FUTA tax that would be owed. Penalties and interest will also be assessed against those amounts. Since the amount owed for FUTA depends upon the amount paid to the state employment fund, the effect of playing this game for both state and federal purposes could be extremely expensive, as one would also face a make-up payment to the state. Delinquent Forms W-2 and corrected Forms W-3 may have to be prepared and filed with the Social Security Administration.
To give you examples of the downside of misclassification, last summer the United States District Court for the Southern District of Iowa held that Raymond Porter and his company, Porter Livestock Products, were liable for the foregoing federal employment and unemployment taxes for employees he improperly attempted to classify as independent contractors. More recently, Mr. and Mrs. David Martin were told by the United States Tax Court that he, the individual who incorporated his own real estate business, was an "employee" of the corporation, it was responsible for these taxes, and was not eligible to deduct the employment taxes that were in dispute. The potential exposure is considerable.
In addition, in particularly flagrant situations, there are two other possible consequences. First, from a purely civil point of view, if the IRS concludes that the business owner should have known that the employees were improperly treated, the owner faces the possibility of the § 6672 trust fund recovery penalty being assessed against him personally if his business can't pay the taxes immediately. Second, in the most flagrant situations, the IRS could take the position that the misclassification is a criminal matter, and a willful failure to pay taxes (a misdemeanor) or an attempt to evade payment of taxes (a felony).
If you are approached by someone with a plan like this, I strongly suggest that you run in the other direction. If you are at all attracted to it, be sure to review every detail of it with your current tax advisor. Don't make a move in this direction without doing so!