In the United States, both at the federal and state level, workers can be classified as either “employees” or “independent contractors.” This distinction carries significant tax repercussions for business owners, particularly with regard to payroll taxes, which are otherwise known as “FICA taxes” or “trust fund taxes.” Depending on whether a worker is classified as an independent contractor or employee, the business owner may or may not be responsible for withholding federal and state income tax or withholding and remitting from employee wages along with paying the employer’s 50% contribution to FICA taxes to the Internal Revenue Service (IRS) and may be required to carry worker’s compensation insurance. As one might imagine, this has led to large numbers of financially-strained business owners deliberately misclassify their workers. However, a recent ruling by the California Supreme Court has strengthened and clarified the existing criteria for worker classification. In light of this ruling, which our California employment tax attorneys will discuss in this article, it is now more crucial than ever for business owners to ensure proper classification of workers – which in turn, could affect California businesses’ employment tax exposure potentially going back to inception. If you are a business owner in California, take heed: this ruling could directly impact your bottom line. Additionally, other States are eventually likely to follow California’s revenue generating example.
Court Ruling Sets New Standards for Classifying Workers as Independent Contractors
On April 30, 2018, the Supreme Court of California issued a ruling which significantly skews the current criteria for classifying workers as employees or independent contractors towards a finding that a worker is an Employee. Prior to the ruling, business owners made worker classification determinations based on the following criteria:
- Does the business exercise “behavioral control” over the worker? For example, does the business owner instruct the worker on the materials he or she is allowed to use, or train the worker on how to perform certain procedures?
- Does the business exercise “financial control” over the worker? For example, does the business owner reimburse the worker when he or she purchases materials, or provide payment on a regular schedule (e.g. biweekly paychecks, hourly wages)?
- What is the nature of the relationship between the business and the worker? For example, does the business owner offer health insurance benefits to the worker, or set an expectation that the work relationship will be ongoing (notwithstanding a termination for poor performance or other issues)?
As you can see, these somewhat ambiguous criteria could arguably leave room for interpretation, opening doorways to abuse of the system. Not only is this disadvantageous for the workers themselves – it also causes tax losses for the Federal and California governments, which, put simply, loses massive amounts of tax revenue each time a business owner dodges his or her employment tax obligations by improperly classifying, what are under a proper interpretation of the law, employees as “independent contractors.”
As many employers have learned the hard way, this practice, is incredibly risky and thus far from being financially shrewd, and can be viewed as employment tax evasion in certain egregious circumstances. Because the IRS has made employment tax evasion an enforcement priority, business owners who continue to engage in this conduct are likely to eventually be hit with substantial civil and/or criminal tax penalties. Criminal exposure can also result from related actions intended to understate workers compensation insurance expense and via employing illegal aliens. Thus, what presently seems like a cost-cutting measure can eventually result in devastating losses which can literally financially destroy a once thriving business and its stakeholders. It’s also important to note that trust fund employment taxes are generally non-dischargeable in bankruptcy.
Depending on the nature of the noncompliance – and the outcome of the resulting Federal or State criminal investigation or worker classification audit – these penalties may take the form of trust fund recovery penalties (TFRPs), criminal tax prosecution for payroll tax evasion, restitution, and/or attorney fees (to say nothing of the potential for incarceration, supervised release, and a permanent felony criminal record). This highlights the importance of complying with Federal and State Tax and Employment law and classifying your workers appropriately.
The recent ruling is expected to improve compliance and curb employment tax fraud by imposing clearer, more rigorous classification standards for business owners in California. In accordance with the Supreme Court’s April 30 decision, business owners must now establish three concrete facts in order to classify workers as independent contractors. These facts are as follows:
- “(A) That the worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact;
- (B) That the worker performs work that is outside the usual course of the hiring entity’s business; and
- (C) That the worker is customarily engaged in an independently established trade, occupation or business of the same nature as the work performed for the hiring entity.”
CA Payroll Tax Fraud Attorneys Handling Worker Misclassification Audits
The IRS’ focus on employment tax fraud can mean jail time for noncompliant business owners who willfully misclassify their workers. (In particular, worker misclassification in the construction industry is especially widespread.) If you are suspected of taking part in an employment tax evasion scheme, you need a skilled, knowledgeable, and aggressive criminal tax defense lawyer on your side especially where facing an employment audit or criminal investigation. Likewise, it will be critical for you to receive worker classification guidance from a business tax attorney if you have recently launched a business, are planning to expand your business, or need help interpreting the new criteria as they pertain to your current workers. Lastly, if you believe you have misclassified workers and wish to get out in front of this problem, contact us to discuss your options, including the IRS’s Voluntary Classification Settlement Program. For a reduced-rate consultation with an experienced California tax attorney, contact the Tax Law Office of David W. Klasing online, or call (800) 681-1295 today.
Also, we’ve expanded our offices! In addition to our offices in Irvine and Los Angeles, the Tax Law Offices of David W. Klasing now have offices in San Bernardino, Santa Barbara, Panorama City, and Oxnard! You can find information on all of our offices here.
Resources
Helpful Q and A library: https://klasing-associates.com/topics/employment-tax-representation-faq/
Helpful YouTube Videos
California Employment Tax Basics: https://youtu.be/4Y8gz1GYuRo
Employment Tax Representation: https://youtu.be/eXaWAgvagn4
What are the penalties for failure to pay employment taxes? https://youtu.be/NqB7G5xkvow
What is the trust fund recovery penalty? https://youtu.be/T0cfuplRZEA
How to determine responsible person for trust fund recovery? https://youtu.be/1RmYYqbd9VI
What can happen after failing to pay employment taxes after notice is given? https://youtu.be/jZxvaXLXKVc
