It is critically important to recognize who among a workforce is an independent contractor subject to 1099 rules and who is actually an employee. Misclassifying employees as independent contractors and failing to provide W-2 forms can subject an employer to back taxes of as much as 41.5%* of the contractors’ wages, according to the IRS. And these penalties can go back for three years.
*A breakdown of back tax penalties:
15.30 % Social Security Tax (on income up to the cap, plus 2.9 % of income above that cap)
20.00 % Federal Income Tax
+6.20 % Unemployment Insurance
41.50 % of the contractor's pay
Even unintentionally misclassifying employees as independent contractors may result in significant penalties and interest. For example:
Intentional or Fraudulent Misclassification
If the IRS suspects fraud or intentional misconduct in employee classifications—in other words if it believes a company deliberately misclassified its workers to avoid taxes—additional fines can be imposed, including criminal penalties. For example, if the IRS determines that employee classifications were intentionally adjusted to avoid overtime pay, the employer could be subjected to penalties that include 20% of all wages paid to the worker, and 100% of FICA that should have been withheld, including both employer and employee portions. In addition, unpaid overtime premiums alone can represent substantial monetary amount, depending on the size of the workforce and the length of time that overtime pay was withheld from eligible employees.
The IRS may levy criminal penalties of $1,000 and/or 1 year in prison for failure to properly classify and withhold wages. If the IRS obtains a felony conviction against a person or company for “attempting to evade or defeat tax,” the fines are up to $100,000 ($500,000 in the case of a corporation), or imprisonment not more than 5 years, or both, together with the costs of prosecution (I.R.C. §7201).
Finally, a responsible person (including corporate officers and employees or members or employees of a partnership) with authority over the financial affairs of the business who willfully fails to collect and pay taxes may be held personally liable for the total amount of the uncollected tax up to 100% under the provisions of the Internal Revenue Code (I.R.C.), as well as subjected to criminal prosecution.
Independent contractors who wrongfully benefited as a result of being paid on a 1099 are virtually free from penalties, although the IRS may audit them and require them to eliminate any business deductions they took. The main focus, however, is on the entity with the deepest pockets--in most cases, the company.
Contact the IRS for further information about fines and penalties for fraud and negligent failure to properly classify workers, and failure to withhold taxes and/or file correct forms.