Employee vs. Contractor Classification Payroll Tax Guide

Summary

• Misclassification can lead to penalties, back taxes with interest, and expanded audit periods, depending on the type of business and recordkeeping.
• Most audits are triggered by unemployment claims, the type of profession, worker complaints and whistleblowing, and cross-state agency audits that alert other state agencies.
• Never discount things that might seem insignificant when considering how you want to document the classification of the individuals you end up hiring.

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In recent years, state payroll tax audits have begun to increase. At the federal level, the IRS also does payroll tax audits, but they are less stringent when it comes to what makes an individual a W2 versus a 1099 contractor. (Be aware that the tests that are usually used by the states are different than those used by the IRS in making an employee misclassification assessment.)

Misclassification can lead to penalties, back taxes with interest, and extended audit periods, depending on the type of business and its recordkeeping practices. Further, many state payroll tax audits can bleed into other state agencies, depending on the type of business. For instance, if you are the owner of a construction business and you consistently misclassify your workers, you could be investigated for your general contractor license, for workers’ compensation, etc. All state and federal tax agencies issue some type of financial penalty for the infraction committed by business owners.

In the last ten years, states have generally become more employee-friendly. Most audits are triggered by unemployment claims, the type of profession, worker complaints and whistleblowing, and cross-state agency audits that alert other state agencies.

Also, always be aware of individuals who are hired for work in the home, such as nannies, executive assistants, chefs, caregivers, tutors, and private nurses, just to name a few relevant professions. Many employers of these workers pay cash and do not issue 1099s, or they issue these workers 1099s not realizing that should these individuals ever file for unemployment, they have a very high chance of being categorized as employees, and thus should have been issued W2s.

As always, proactive documentation is a business owner’s best defense. When deciding whether to classify a hire as a W2 or a 1099 worker, consider their relationship to your business. A good guideline that we always give to clients is that if the individual is essential to your business, usually they will be viewed as a W2 employee. There are, of course, instances where you can have an individual who is considered essential to your business and can be a contractor. When hiring these 1099 individuals, documenting their contracts specifically tailored to their actions is essential. Further, make sure that those individuals provide evidence of their separate and independent business operations, such as city business licenses, business cards, business insurance, incorporation documents, and EIN.

Employers have lost independent contractor classification in audits because a worker lacked a simple $35 city business license. Never discount things that might seem insignificant when considering how you want to document in your business files the classification of the individuals you end up hiring. Always consult either a tax or employment attorney if you feel that you have questions related to hiring 1099 individuals for your business. Moving forward with unanswered questions or inadequate business records can and will create a bigger headache than necessary if you are ever contacted for a payroll audit.

Endnotes

Authors

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Authors

Allison D. H. Soares

Lauren Suarez

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