Independent Contractor or Employee? The Consequences of Getting it Wrong

The Far Reaching Trust Fund Recovery Penalty

The Trust Fund Recovery Penalty, Internal Revenue Code (“IRC”) Section 6672, requires employers to withhold from the pay of employees properly calculated FICA, (i.e. Social Security) taxes, Medicare taxes, and income taxes. An employer must withhold taxes on behalf of its employees for payment to the government; the taxes are considered to be held in trust on behalf of the government. Employees are allowed a credit against their tax liability for the amount of taxes withheld from their wages, regardless of whether the employer actually pays the funds to the Feds.

Failing to withhold from the pay of employees, or failing to pay the proper withholdings, may subject a business to tax penalties and interest. Incorrectly characterizing service providers as independent contractors and thus failing to withhold the properly calculated payroll taxes likewise may result in significant tax penalties and interest being assessed.

IRC Section 6672 provides the Service with the authority to collect 100% of the amount unpaid from “responsible person(s)”.

These payroll tax penalties are not only assessed and collected from a business, they may also be assessed and collected against individuals associated with the business – CPAs, bookkeepers, office managers, officers, directors, etc.

IRC Section 6672 provides the Service with the authority to collect 100% of the amount unpaid from “responsible person(s)”. The statute is far reaching in terms of who may be considered a “responsible person” for the payment of the trust fund taxes, and the courts have interpreted the definition of a responsible person quite broadly. See, e.g., Denbo v. United States, 988 F.2d 1029, 1032 (10th Cir.1993); [“The responsible person generally is, but need not be, a managing officer or employee, and there may be more than one responsible person. Indicia of responsibility include the holding of corporate office, control over financial affairs, the authority to disburse corporate funds, stock ownership, and the ability to hire and fire employees. Among other things, therefore, a corporate officer or employee is responsible if he or she has significant, though not necessarily exclusive, authority in the general management and fiscal decision making of the corporation.”]

Most significantly, one or more persons may be deemed by the Service liable for the penalty, and each may be held responsible for 100% of the penalty.

Nonparticipating officers or directors have found themselves liable for the employer’s entire trust fund tax liability for taxes they didn’t even know were owed. George v. U.S., 819 F.2d 1008 (11th Cir. 1987). Accountants have been found responsible for the entire trust fund payroll owed by their clients. Bax v. U.S., 92-2 USTC pp. 50,354 (N.D. Ill. 1992). Most significantly, one or more persons may be deemed by the Service liable for the penalty, and each may be held responsible for 100% of the penalty. The IRS is not required to collect from the employer first. If a company is without sufficient liquid assets to meet its 6672 obligations, the IRS may seek to collect the entire penalty from a responsible person rather than the company.

California’s Penalty For Worker Misclassifications

Further complicating the issue, California Senate Bill 459 (“SB 459”), which became effective on January 1, 2012 creates significant and daunting new civil penalties for employers who “willfully” misclassify as independent contractors individuals who, in the opinion of either, the California Labor and Workforce Development Agency or the State Labor Commissioner, should be treated as employees.

The bill also includes what has been termed the “Scarlet Letter” rule which requires employers who are found to have engaged in misclassification “to display prominently” for one year on their websites a notice to employees and the general public announcing that the employer “has committed a serious violation of law by engaging in willful misclassification of employees.”

The draconian law imposes penalties between $5,000 and $15,000 for each violation. Where the employer is found to have engaged “in a pattern or practice of [those] violations,” the civil penalty is increased to $10,000 to $25,000 per violation. What the law fails to specify is the effect of a single classification decision affecting a group of similarly situated individuals. Given the grave tenor of the statute it should be assumed that multiple violations stemming from a single categorical misclassification, will result in multiple independent fines and potentially, the heightened penalty.

The bill also includes what has been termed the “Scarlet Letter” rule which requires employers who are found to have engaged in misclassification “to display prominently” for one year on their websites a notice to employees and the general public announcing that the employer “has committed a serious violation of law by engaging in willful misclassification of employees.”

Accountants, insurance brokers and outside human resource professionals should be mindful of the provision which holds non-attorney advisors jointly and severally liable with the employer if they knowingly advise the employer to treat an individual as an independent contractor and the individual is not found to be an independent contractor. The penalty structure lacks for a definition of what constitutes “willful” misclassification of an employee. While it is reasonable to presume the term ‘willful’ suggests some scienter on the part of the employer, this presumption may be misguided. To the extent this statute mirrors the federal statute, it is prudent to assume that any violation will be deemed “willful” absent evidence to the contrary reviewed on a case by case basis.

California’s statute lacks any safe harbor provision similar to that afforded by the Feds, and employers may be less willing to voluntarily reclassify workers. In some cases, California’s rule may prevent employers from participating in the otherwise generous Federal settlement program discussed below.

The IRS’s Voluntary Worker Classification Settlement Program

In contrast to California, the IRS launched a program on September 21, 2011, that enables employers to resolve past worker classification issues and achieve certainty under the tax law at a low cost by voluntarily reclassifying their workers. The Program provides taxpayers not under examination with an opportunity to voluntarily reclassify their workers as employees for future tax periods, with limited federal employment tax liability for the past non-employee treatment.

Essentially, participants will pay one percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, will not be liable for any interest and penalties on the liability, and will not be subject to an employment tax audit with respect to these reclassified workers for prior years. Participating employers will, for the first three years under the program, be subject to a special six year statute of limitations, rather than the usual three years that generally applies to payroll taxes. Those desiring to participate must file at least 60 days before the date they want to begin treating the workers as employees.

Federal Penalty Abatement

For those who did not participate in the Settlement Program, and who are assessed penalties at the Federal level, these penalties may be abated upon a showing that the responsible person did not act willfully, i.e. intentionally. If an employer has a reasonable basis for believing that workers are independent contractors for whom withholding is not required, they may be able to avoid liability. See Crowd Mgmt. Services, Inc. v. U.S. 889 F. Supp. 1313 (D. Or. 1995) [court concluded that the responsible person took significant steps to determine whether withholding was required, and has a reasonable basis for concluding that no withholding taxes were due, such that his actions were not willful]. Although the Service may collect the penalty from the employer and/or the responsible persons, the stated IRS policy is to collect the income and employment taxes only once – whether it be from the employer or a responsible person or some combination thereof. IRS Policy Statement P-5-60 (2-2-93). Courts also have recognized that the government is entitled to only one satisfaction. U.S. v. Hukabee Auto Co., 783 783 F.2d 1546 (11th Cir. 1986); Brown v. U.S., 591 F.2d 1136 (5th Circ. 1972). As a result, a penalty assessed a responsible person is abated to the extent that the underlying tax obligation is paid. McCray v. U.S., 910 F.2d 1289 (5th Cir. 1990); Gens v. U.S., 615 F.2d 1335 (Ct. Cl. 1980).

While the IRS has provided employers some safe harbor with regard to the classification of its employees, California offers no such protection.

While the IRS has provided employers some safe harbor with regard to the classification of its employees, California offers no such protection. To this end it would behoove employers questioning the classification of their work force to consult with qualified counsel to see if they may be able to benefit from the get out of jail free card offered by the IRS’s new policy without exposing themselves to hefty fines levied at the State level. For those rendering advice to employers on worker classification, proceed with caution.

Janet L. Everson is a Shareholder of Murphy Pearson Bradley & Feeney. Ms. Everson holds an LLM in Tax and focuses her practice on tax controversy and litigation defending accountants and lawyers in professional liability suits, and in dealing directly with the federal and state tax authorities correctinglate elections, reducing or eliminating penalties or otherwise mitigating damages before litigation is commenced.

Matthew A. Cebrian is a Director of Murphy Pearson Bradley & Feeney. Mr. Cebrian represents management clients in connection with all types of matters under federal and state law. Mr. Cebrian specializes in claims involving wrongful termination, harassment, wage and hour, discrimination and whistle-blowing/retaliation claims. Mr. Cebrian also advises clients with regard to employment related risk management and crisis management.