Tax Complications of Misclassifying Employees

Misclassifying employees as independent contractors might seem like a harmless administrative error, but the tax consequences can be significant—and costly. As a business owner, understanding the difference is critical to staying compliant with IRS regulations and avoiding unexpected penalties.

Why Classification Matters

The IRS uses specific criteria to determine whether a worker is an employee or an independent contractor. The key factors fall into three categories:

• Behavioral control: Do you direct how and when the worker performs their tasks?
• Financial control: Do you control how the worker is paid and whether they can seek outside business?
• Relationship of the parties: Is there a written contract or expectation of ongoing work?

If the IRS determines you’ve misclassified a worker, the consequences can include unpaid payroll taxes, interest, penalties, and liability for benefits like health insurance and overtime.

Common Missteps

Many small businesses inadvertently misclassify workers because:

• They assume paying someone on a 1099 form makes them a contractor.
• The worker prefers being a contractor for perceived tax benefits.
• The business wants to avoid the cost of payroll taxes or benefits.

Unfortunately, intent doesn’t always protect you from consequences. If the facts indicate that the worker functions as an employee, that’s how the IRS will classify them—regardless of any signed agreement.

What Happens If You Get It Wrong

If you’re audited and found to have misclassified an employee, you could be responsible for:

• Back taxes: Including Social Security and Medicare contributions.
• Penalties: Up to 100% of the taxes owed in some cases.
• Legal exposure: Workers may sue for lost wages or benefits.

In severe cases, the Department of Labor may also become involved, especially if wage and hour laws are violated.

How DWD CPAs & Advisors Can Help

Our team of CPAs can help you analyze your workforce and determine proper classification. If you suspect a mistake, we can assist with voluntary correction programs that may reduce penalties. It’s also wise to periodically review job descriptions and worker relationships to ensure they meet IRS guidelines.

Misclassifying workers can be more than a clerical error—it’s a financial risk. Work with a CPA to get it right the first time.