Earlier this year, the First Circuit United States Court of Appeals issued its decision in United States v. Albania Deleon, 704 F.3d 189 (1st Cir., January 11, 2013). This case illustrates that worker misclassification may, in addition to the imposition of taxes and civil penalties, lead to criminal sanctions, including imprisonment.
Albania Deleon owned and operated two businesses: an asbestos abatement training school (“ECT”) and a temporary employment agency (“MSI”). This case focuses on Ms. Deleon and MSI. MSI supplied temporary workers to asbestos abatement contractors.
MSI maintained two separate payrolls for its workforce. One payroll reported a minority of the workers as employees, proper withholding of payroll and income taxes was done, and Form W-2s were issued to the employees. MSI reported in writing to both its customers (including governmental entities) and the occupational safety division of local government that it was responsible for and was complying with all employee withholding tax obligations.
The second payroll, which encompassed most of MSI’s workers, treated the workers as independent contractors—no withholding was done. Rather, IRS Form 1099s were issued to the workers. MSI told its accountants that these workers were independent contractors. Evidence in the trial record indicated Ms. Deleon had absolutely no factual basis for that conclusion.
In late 2006, as a result of an anonymous tip to the government that MSI was violating immigration laws and was involved in fraudulent payroll activity, state and federal investigators raided the offices of both companies. Based upon the information gathered in the raid, including computer records, the IRS concluded MSI had fraudulently avoided paying over $1,000,000 in payroll taxes.
Ms. Deleon, owner of both companies, was charged with several counts of:
1. mail fraud;
2. making false tax returns;
3. procuring false tax returns; and
4. conspiracy to violate multiple federal criminal laws.
After an eleven-day trial, Ms. Deleon was convicted on all counts. She is now serving 87 months in federal prison.
Ms. Deleon had no basis for her characterization of a majority of the workers as independent contractors. She simply reported them as independent contractors to reduce her tax liability. She told her customers and the government she was properly treating the workers as employees. Worker misclassification cost her 87 months behind bars.
This case illustrates worker misclassification can lead to more than simply a tax liability and civil penalties. If you are interested in reading more about worker classification, please click on the links below:
As many employers have painfully learned, misclassifying employees as independent contractors can be an expensive mistake. Worker misclassification may become even more costly in 2014, when a new potential trap for the unwary will exist. If a non-complying employer gets caught in this new trap, it could be faced with significant monetary penalties.
Beginning in 2014, as a result of the Patient Protection and Affordable Care Act, employers who misclassify employees as independent contractors may be subject to an additional penalty regime. Section 4980H(a) of the Internal Revenue Code (the “Code”) imposes a penalty on “large employers” who fail to offer full-time employees health insurance with a minimum level of coverage. Because employers generally do not provide health care coverage to independent contractors, reclassification of an independent contractor to a full-time employee could trigger this penalty.
Large Employers and Full-Time Employees
The new penalty applies only to “large employers.” Whether an employer is a large employer is not always a simple determination. In general, a large employer is any employer with fifty or more full-time employees.
A full-time employee is an individual who works at least thirty hours per week. Currently, the Internal Revenue Service (“IRS” or “Service”) proposes the term “employee” include an individual who is an employee under the “common-law standard.” Prop. Treas. Reg. § 54.4980H–1(a)(13). A determination under the common law standard hinges on whether the employer has the right to control the individual who performs the services. Whether or not the “employer” exerts actual control is irrelevant. In determining whether the employer has the right to control, the Service analyzes numerous factors. Due to the large number of factors, the Service’s determination of whether an employer has the right to control a worker is highly subjective and its determinations are not always consistent.
Beginning in 2014, an employer may be subject to a penalty attributable to each month when:
- It is a “large employer” (because of reclassification or otherwise);
- It fails to offer all of its full-time employees (and dependants) the opportunity to enroll in “minimal essential coverage” under an “eligible employer-sponsored plan”; and
- At least one full-time employee is certified to the employer as having, for that month, enrolled in a qualified health plan with respect to which an “applicable premium tax credit or cost-sharing reduction” is allowed or paid.
IRC § 4980H(a). For each month the employer is noncompliant, the penalty is equal to:
- The applicable payment amount per month (currently 1/12 of $2,000 or $166.67, adjusted for inflation after 2014), multiplied by
- The number of full-time employees during any month (reduced by 30).
The penalty can be surprisingly high. Consider the following example:
Example. For all of 2014, an employer reports it has forty-five full-time employees and thirty-five independent contractors. On audit, it is determined the independent contractors are actually full-time employees and, therefore, the employer is a “large employer.” If one reclassified employee receives a tax credit, the employer becomes subject to the 4980H(a) penalty because it fails to offer minimum essential coverage and has eighty full-time employees.
$100,000 Penalty. For 2014, (for eighty employees) the penalty would be (80 – 30) × $2,000, or $100,000. In other words, for each employee over the thirty-employee threshold, the employer owes $2,000 ($166.67 × 12 months), for a total penalty of $100,000 ($2,000 × 50 (that is, 80 ? 30)).
Section 4980H(a) of the Code imposes the penalty on large employers who fail to offer their full-time employees health insurance meeting a minimum level of coverage and where at least one employee receives a tax credit or cost sharing reduction. This penalty could be triggered by an unsuspecting, otherwise compliant employer, if the government reclassifies one or more of its independent contractors as employees. In such cases, the employer could easily face a huge additional penalty.
Incorrectly classifying workers could become very costly with the addition of this new penalty to the government’s arsenal. As exemplified above, some employers could face penalties in excess of $100,000 per year. Thus, it is very important employers evaluate whether their independent contractors are at risk of being reclassified as employees.
According to a Bureau of Labor Statistics study conducted almost 8 years ago, approximately 10.3 million workers in the United States, or 7.4% of the workforce, are classified as independent contractors. Today that number, despite recessionary times, is likely dramatically larger.
The federal government, based upon recent case studies including federal and state income tax and unemployment tax audits, recently concluded many workers classified as independent contractors are actually employees. Consequently, worker classification is currently a hot topic for the Internal Revenue Service, the state departments of revenue, and other federal, state and local agencies.
Government focus on worker classification is not a new phenomenon. Due to current economic and political pressures, however, it has risen to the forefront of governmental attention. During the last few years, federal, state and local agencies have dramatically increased audit activity, targeting worker misclassification.
In 2011, to encourage worker classification compliance by businesses, the Internal Revenue Service (“IRS” or “Service”) adopted a voluntary compliance program (commonly referred to as the “Voluntary Worker Classification Settlement Program” or “VWCSP”). The program provides businesses: (i) the opportunity to get into compliance by making a minimal payment covering some of their past payroll tax obligations (i.e., an amount equal to just over one percent of the wages paid to reclassified workers for the past year without penalties or interest); and (ii) a fresh start going forward relative to worker classification. The problem with the 2011 program is the stringent eligibility requirements prohibit many businesses from participating in the program. It requires the applicant meet the following:
- Consistently treated the workers in the past as nonemployees;
- Filed all required Forms 1099 for the workers for the previous three years;
- Not currently be under audit by the IRS; and
- Not currently be under audit by the Department of Labor or a state agency concerning the classification of the workers.
The second requirement, the filing of Forms 1099, has been the roadblock for many businesses. In order to alleviate this participation barrier, the Service recently removed the roadblock. Unfortunately, this new program is only available for a limited period of time. Businesses desiring to participate in the program must apply on or before June 30, 2013.
Benefits of the Voluntary Worker Classification Settlement Program
Participation in the VWCSP may have significant benefits for businesses including:
- The business will not owe any interest or penalties;
- The business will not be audited on worker classification matters relative to the workers who are the subject of its application;
- The business will only be required to pay a small fraction of the potential employment tax liability to bring itself into compliance; and
- The business obtains some worker classification certainty going forward.
Temporary Expansion of the Voluntary Worker Classification Settlement Program
Qualification under the VWCSP, as expanded, requires the business to pay a higher amount of taxes than under the original program. Participation is still subject to the eligibility requirements (except the Forms 1099 filing requirement). The business must submit an application, and if accepted, enter into a closing agreement with the IRS. Assuming the VWCSP requirements are satisfied, the employer must treat the workers (or class of workers) subject to the VWCSP as employees going forward.
The business must satisfy the following requirements to be eligible for this temporary expansion of the VWCSP:
- It consistently treated the workers (or class of workers) subject to the VWCSP as nonemployees;
- It is not under a federal employment tax audit by the IRS (including as a member of an affiliated group under Section 1504(a) of the Internal Revenue Code); and
- It is not under an audit concerning the classification of the class or classes of workers subject to the VWCSP by the U.S. Department of Labor or any state government agency.
Note: A previous IRS or Department of Labor audit on the class or classes of workers subject to the VWCSP will not preclude eligibility if the business has complied with the results of the audit and is not currently contesting the classification.
- The business must submit an application (Form 8952) before June 30, 2013;
- The IRS will contact the business or its authorized representative with instructions on how to file the Forms 1099 once the IRS has reviewed the application and determined eligibility;
- The business must contact the IRS to confirm the Forms 1099 have been electronically filed and furnish the Forms 1099 to the workers subject to the VWCSP; and
- Once the IRS accepts the application, the business must enter into a closing agreement with the IRS to finalize the VWCSP’s terms and pay all amounts due under the closing agreement.
Effect of the Voluntary Worker Classification Settlement Program
The business must treat the workers (or class of workers) who are reclassified under a VWCSP agreement as employees for federal employment tax purposes going forward. It should expect the state(s) and local governments where these workers are located to assert these workers are also employees for state and local employment tax purposes.
The expanded VWCSP requires the business pay the following:
- Twenty-five percent (25%) of the federal employment tax liability for the most recent tax year that would have been due on the compensation of the workers subject to the VWCSP; and
- A reduced penalty for unfiled Forms 1099 for the previous 3 years for workers subject to the VWCSP (the penalty for unfiled Forms 1099 is graduated, based on the number of unfiled Forms 1099, and is capped at a maximum amount of $10,000).
This temporary VWCSP may be a viable option for businesses who were previously ineligible because of the failure to file the required Forms 1099. The amnesty from federal employment tax audits based on employee classification may be an attractive option for businesses which are nervous about potential employee classification issues, including the penalties and interest associated with misclassification. However, it is not without risks, including:
- The IRS maintains discretion to deny a business’ application under the program. So, if a business submits an application that the IRS denies, it will be denied the benefits of the program and will also identify itself to the IRS as having workers which it believes may be misclassified, and potentially subject itself to further investigation by the IRS. This could lead not only to increased burden and expense on behalf of the business, but also potential tax liability for those misclassified workers.
- The program only offers protection from the IRS, not the Department of Labor or state departments of revenue, and other state and local agencies. Further, the program does not preclude the IRS from sharing information with other government agencies.
- The business must agree to extend the statute of limitations on the assessment of employment taxes for the first, second and third calendar years beginning after the date on which the business has agreed under the closing agreement to begin treating the workers as employees. The extended statute of limitations under the program is not limited to employee misclassification issues, but will allow the IRS to review a participating business’s entire employment tax compliance during the extended period.
- The amount of taxes due under the expanded program are much higher than under the original VWCSP.
- The expanded program added a penalty for unfiled Form 1099s, a new cost of entry.
The new VWCSP offers businesses significant advantages. Given the potential risks and added costs of entry, however, businesses are well advised to fully evaluate the risks and rewards prior to applying for the program. The assistance of tax counsel well versed in this area of the law is warranted.
Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
Upcoming Speaking Engagements
- "S Corporation Distributions – The Ins and Outs," New York University 77th Institute on Federal TaxationNew York, NY, 10.21.18-10.26.18
- "Developments in the World of IRC Section 1031 Exchanges, including the Impact of the Tax Cuts and Jobs Act," IRS Tax Practitioners ForumPortland, OR, 10.31.18
- Portland, OR, 11.5.18
- "The Tax Cuts and Jobs Act – What It May Mean to Your Clients," Estate Planning Council of Portland Mini-SeminarPortland, OR, 11.7.18
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- "S Corporation Distributions – The Ins and Outs," New York University 77th Institute on Federal TaxationSan Diego, CA, 11.11.18-11.16.18