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The employer who erroneously classifies employees as independent contractors may be liable for past-due taxes, including interest and penalties. Federal tax liability is calculated in either of two ways, depending on whether the IRS finds the error to be an intentional disregard of the law. If the employer did not intentionally disregard the law, it will be liable for (1) the employer’s one-half of the FICA tax, (2) either 20% or 40% of the employee’s share of the FICA tax, and (3) either 1.5% or 3% of the amounts paid to the reclassified employee, in lieu of federal income tax withholding.1 In this instance, the employer receives no credit for any federal income and self-employment tax the employee already paid. There is no interest on the liability if it is reported and paid in a timely fashion.

If the IRS finds that the employer intentionally disregarded the law, the company is liable for the full amount of the income taxes that should have been withheld. In this case, however, liability is abated to the extent the employer can demonstrate that the reclassified employee paid self-employment tax and/or individual income taxes.

The company is also liable to the state of Colorado for taxes that should have been paid or withheld by the employer. Payment of the tax that should have been withheld may be abated if the employer can demonstrate “the failure to deduct and withhold … was due to reasonable causes and not due to willful neglect.” Unemployment tax is an employer obligation and is not withheld from the employee’s wages; liability for unemployment tax, and interest, cannot be so abated.

The federal tax code generally provides that the employer is responsible for withholding and payment of FICA and FUTA1 taxes. The “employer” is the person with control of the payment of wages. In most instances, then, the responsibility for the payroll taxes of temporary or leased employees resides in the leasing agency rather than the client company.

Colorado law specifically addressing misclassified employees. In 2009, to address the variety of problems caused when employers misclassify employees as independent contractors, the legislature enacted West’s C.R.S.A. § 8-72-114 to provide significant disincentives to this practice. The negative consequences include fines of up to $5,000 per misclassified employee for the initial finding an employer willfully disregarded the law. Subsequent or second offenses may result in fines of up to $25,000 per employee and a two-year ban on state contracts.

The employee misclassification law uses the same definition of “employee” as is found in the Colorado Employment Security Act. The law permits anyone to file a written complaint that an employer has misclassified any worker as an independent contractor. The Director of the Division of Employment and Training in the Colorado Department of Labor and Employment has 30 days after a complaint is filed to determine whether to investigate.

The Director must establish a mechanism for employers to obtain opinion letters regarding whether workers are employees or independent contractors and set the amount employers will be charged for that service.

In addition to problems under this law, tax laws, unemployment insurance, and workers’ compensation insurance laws, employers who misclassify employees may also owe the workers minimum wage and overtime. Of course, someone who was misclassified as an independent contractor will have an employee’s protections such as those under employment discrimination laws and wage laws.

IRS Settlement Program to encourage proper classification.

To encourage proper classification of workers who are really employees but who have been treated incorrectly as independent contractors, the IRS permits employers voluntarily to reclassify those workers, or classes of workers, as employees for subsequent calendar quarters.15 Effective beginning the last calendar quarter of 2011, the Service’s Voluntary Classification Settlement Program (VCSP) permits an employer to reduce its exposure to federal tax penalties for misclassifying workers. To be eligible for the VCSP the employer must:

          1. have consistently treated the worker as an independent contractor and never as an employee;

          2. have filed Forms 1099 reporting its payments to the worker for the past three years;

          3. not already be under an audit by a federal or state agency for the independent contractor classification; and

          4. file IRS Form 8952 at least 60 days prior to the reclassification.

If an employer qualifies for the VCSP, the IRS will not assess interest or penalties, although other federal and state agencies might.

An employer participating in the VCSP must agree prospectively to treat the subject workers, or class of workers, as employees for future tax periods. In exchange, the employer:

          • Will pay 10% of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of section 3509(a) of the Internal Revenue Code.

          • Will not be liable for any interest and penalties on the amount; and

          • Will not be subject to an employment tax audit with respect to the worker classification of the workers being reclassified under the VCSP for prior years.

Participating employers must also consent to a special six year statute of limitations instead of the regular three years that applies to payroll taxes.

In 2012, the federal Department of Labor and the Colorado Department of Labor and Employment entered into an agreement to share information obtained in their respective audits of employers about workers they determine were misclassified as independent contractors and are actually employees. This agreement means employers who misclassify workers will face fines, back-pay awards and related consequences under both state and federal laws and regulations.

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