8729 / What are the consequences if an employer wrongly characterizes an employee as an independent contractor?

The proper classification of individuals by an employer as either employees or independent contractors is important in many areas, and an employer who misclassifies its workers will be responsible for the consequences of the misclassification.

An employer who misclassifies an employee as an independent contractor may be liable for that employee’s Social Security taxes because, in an employer-employee relationship, the employer is responsible for one-half of the tax owed, and the employer is responsible for deducting the employee’s portion of the tax from wages.¹ Independent contractors, on the other hand, are liable for the entire amount of the tax, but are entitled to deduct one-half of the taxes paid (see Q 8724).

The IRS has ruled that if an employer wrongly classifies an individual as an independent contractor, the IRS can offset the refund of any self-employment taxes paid by that individual, but only with the employee portion of the employment taxes that would have been owed had the employee been properly classified.²

Therefore, if an employer hires an independent contractor who is later found to be an employee, the employee can claim a refund for the self-employment taxes paid while the employee was erroneously believed to be an independent contractor. The IRS, when processing the refund, can reduce the amount refundable to the employee by the employment taxes the employee would have paid with proper classification. The employer, however, remains liable for the remaining balance that was refunded to the employee.

The Tax Court has recently declined to apply a federal common law successor in interest standard in determining successor liability in the employment tax context. In this case, a taxpayer had been a partner in several partnerships that were later dissolved, with their assets (and certain operations) conveyed to a limited partnership in which that taxpayer became a limited partner. The IRS issued a notice of determination concerning worker classification, and attempted to collect employment taxes from the newly formed limited partnership as a successor in interest of the previously operating partnerships. While the Tax Court did agree with the IRS’ worker classification, it held that the newly formed limited partnership was not liable for the resulting employment tax deficiency as a successor in interest because it had not expressly assumed the liabilities of the previously existing partnerships. The limited partnership was, however, liable for employment taxes owing since the date it assumed the operations that were carried on by the dissolved partnerships. The court did note that the IRS could have possibly succeeded had it used a transferee liability theory in attempting to collect the employment taxes from the newly formed partnership.³

Further, an employee who has been wrongly classified as an independent contractor may be entitled to claim benefits under the benefit plans that the employer has established for traditional employees. For example, the Ninth Circuit has held that certain “leased” employees that an employer leased from an employment agency, and sought to classify as independent contractors, could claim their rights to benefits under that employer’s employee benefit plans (including health insurance coverage) if they qualified as employees under the 20-factor test laid out by the IRS in Revenue Ruling 87-41 (see Q 8723).⁴

Similarly, in Vizcaino v. Microsoft Corp.,⁵ the Ninth Circuit held that individuals whom the employer sought to characterize as independent contractors may have had rights under the employer’s benefit plans after an IRS audit found that the individuals were common law employees, and the employer conceded that it had mischaracterized the individuals.

In contrast, the Tenth and Eleventh Circuits have held that the contract language of the employer’s benefit plans will control. In these circuits, “leased” employees that met the 20-factor test to qualify as employees were not permitted to claim benefits under the employer’s benefit plans when the plan language specifically excluded temporary and leased employees.⁶ This was the case even though the leased employees at issue performed substantially similar services as the employer’s common law employees who qualified for plan benefits.

Until this split in the circuits is resolved, it seems that the question of whether an employee who is wrongly characterized as an independent contractor is entitled to employment related benefits under the employer’s benefit plans will be answered based on where the question is litigated.

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Planning Point: Upon a request by a firm or worker, the IRS will determine whether a specific individual is an employee or independent contractor, provided the request is submitted for a tax year for which the statute of limitations on the tax return has not expired. A request is made by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. Form SS-8 is filed to request a determination of the status of a worker for purposes of federal employment taxes and income tax withholding. A Form SS-8 determination may be requested only in order to resolve federal tax matters.⁷