Misclassification of Employees: Payroll Audits Increase


Misclassifying employees as independent contractors can create significant problems for employers. If an employer is found to have misclassified an employee, the employer could be subject to, among other things, varies fines, penalties, interest, and back taxes. In order to curb the widespread misclassification of employees as independent contractors, the U.S. Department of Labor, Wage and Hour Division, and the Minnesota Department of Labor and Industry have been working together pursuant to an agreement to conduct joint investigations, share information, and coordinate enforcement efforts. The Internal Revenue Service (“IRS”) has also increased its focus on investigating the classification of workers in order to recoup lost revenue from failure to pay payroll taxes.

Increase in Payroll Audits

The joint initiative between state and federal agencies has focused, in part, on increasing payroll audits over the past few years. These audits scrutinize whether an employer is misclassifying an employee as an independent contractor, and therefore avoiding Social Security, Medicare, and other payroll taxes. The impact a payroll audit can have on a business is substantial. Audits are typically conducted with little warning, usually require a significant amount of time from the employer and key staff members, and can result in unplanned costs and legal expenses, not to mention fines, penalties, interest, and back taxes if an employer is found to have misclassified employees as independent contractors. In order to avoid the risks associated with a payroll audit, it is recommended that employers work with an experienced business and employment law attorney to conduct an internal audit. Certain options are available to an employer if it is determined that one or more workers need to be reclassified as employees. For example, an employer may qualify for the Voluntary Classification Settlement Program (“VCSP”).

Voluntary Classification Settlement Program

In an effort to encourage proper classification of workers, the IRS developed and implemented the VCSP. The VCSP provides an avenue for employers to voluntarily reclassify their workers as employees for future tax periods, avoid certain penalties and interest, and receive partial relief from past due employment taxes. In order to participate in the VCSP, certain conditions must be met. Specifically, an employer must have, among other things, consistently treated the worker as an independent contractor, the employer is currently not under an audit by the IRS, and the employer filed any required Forms 1099. If an employer satisfies the requirements under this program, the employer will pay 10% of the amount of employment taxes that would otherwise have been due for the most recent tax year on the compensation paid to the workers being reclassified. This amount is calculated under the reduced rates of section 3509(a) of the Internal Revenue Code. In addition, the employer will not be audited for purposes of employment taxes for the years prior to reclassification.

About the Author: Attorney Steven M. Cerny is a Partner at JUX Law Firm and focuses on business and employment law, and litigation. 

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