As a business owner, it is important for you to understand if your company's workers are employees or independent contractors. The difference is a big issue. The IRS assumes a worker is an employee unless the employer can prove otherwise. As an employee, you—the employer—are obligated to pay taxes and abide by state and federal laws regarding benefits, wages, and hours.
The IRS closely monitors businesses to be sure they are not incorrectly classifying workers as independent contractors instead of employees. Independent contractors do not have employment taxes withheld, and other taxes are not paid for contractors that are paid for employees. If you incorrectly treat workers as independent contractors and the IRS determines they are employees, it could cost your business money in fines and penalties for underpayment of employment taxes.
IRS Section 530 Exceptions
There is one exception to this rule. Your business may be able to meet special requirements to avoid classifying workers as employees and paying employment taxes on their wages. This relief is discussed in Section 530 of the Internal Revenue Code.
Section 530 relief is an example of a safe harbor provision under some federal laws. A safe harbor provision allows protection from liability or payment if the person or business can show a good faith effort to comply with the law. Usually, this means compliance with specific requirements.
What Happens if an Employer Doesn't Correctly Classify Workers
Let's say Company C has some workers that they considered independent contractors. For two years, the company didn't withhold federal income taxes from these workers and it didn't deduct FICA taxes (for Social Security and Medicare) from payments to these people.
The IRS came to the company and determined that the workers should have been treated as employees. Since no FICA taxes were withheld for that two-year period, the company could have been liable for those payments, plus fines and penalties.
How Section 530 Protection Works
Section 530 of the Internal Revenue Code (PDF) discusses "Controversies Involving Whether Individuals are Employees for Purposes of Employment Taxes." Section 530 provisions allow a business to avoid paying employment taxes if the business treated workers as independent contractors, but the IRS says they are employees.
Section 530 established a safe harbor for employers. This means that a business may not be liable for the employment taxes, as in the example above. If the business can show it had a reasonable basis for treating workers as independent contractors, the taxes, fines, and penalties may be waived.
Section 530 Relief Requirements
Section 530 Relief Requirements list three requirements for receiving a safe harbor exemption. All three must be present:
1. Reasonable Basis. Your business must have a reasonable basis for not treating the workers as employees. This reasonable basis might be established by:
- A related court case or ruling by the IRS
- A previous IRS audit that included an examination of employment taxes at a time when you treated similar workers as independent contractors and which did not result in IRS reclassification of these workers
- You can show that a significant segment of your industry treated similar workers as independent contractors
- You relied on some other reasonable basis, like the advice of a business attorney or accountant who knew the facts about your business
Substantive Consistency. In addition, you and any predecessor employers must have treated the workers and any similar workers ONLY as independent contractors. If you treated similar workers as employees, this relief is not available.
Reporting Consistency. Finally, your business must at all times have filed all federal tax returns consistent with your treatment of the workers as independent contractors and not employees. This treatment would include giving the workers Form 1099-MISC as annual wage summaries, and not at any time W-2s. Relief is not available for any year and for any workers for whom you did not file the required information returns.
To continue the example above, Company C:
- Can show that treating the workers as independent contractors was an industry-standard (Reasonable Basis)
- Treated all similar workers as independent contractors (Substantive Consistency)
- Consistently prepared 1099-MISC forms each year for all of the workers in this case (Reporting Consistency).
Another Possibility for Determining Worker Status
If you aren't sure if you are correctly treating workers as independent contractors, you can ask the IRS for a determination. Use IRS Form SS-8 to request a determination from the IRS. The form takes you through a series of questions about your relationship with the workers. The IRS reviews the situation and issues a determination. The IRS says that an SS-8 review is not connected to a Section 530 evaluation; these are two separate processes.