New Penalties for Independent Contractor Misclassifications

Senate Bill 459, signed into law by Governor Brown in October 2011, makes the “willful misclassification” of employees as independent contractors “unlawful” and provides for severe penalties that range upward of $25,000 per offense. To better understand how this new law applies we look to how the IRS characterizes an employee versus an independent contractor.

The IRS has specific criteria for determining the status of an individual as an employee or a contractor. Generally, the IRS will treat a worker as an employee if the following situations apply:

• You or your representative tells the worker where, when, and how to work.
• The worker is paid by the hour, weeks, or month, you furnish tools and materials.
• You set the workers work hours.

A contractor, on the other hand, is a worker who contracts with an employer to complete a particular piece of work or task. The contractor sets their own hours and is paid for the specific job or service. From the employer’s side, treating someone as a contractor simplifies a lot of payroll and employer regulation requirements. These benefits may cause some employers to incorrectly classify someone working for them as a contractor.

Willful misclassification is defined in the new law as “avoiding employee status for an individual by voluntarily and knowingly misclassifying that individual as an independent contractor.” Ignorance is not a defense for willful misclassification of an employee. Some courts have defined “knowingly” in this context as including constructive knowledge, which can mean what a professional purportedly should have known. No longer are you considered safe from penalties because you filed forms 1099-Misc.

If you are found to willfully misclassify an employee as an independent contractor, the penalty is $5,000 to $15,000 for each violation (a single misclassified individual). If the court determines there is a “pattern and practice” of these violations, a penalty of $10,000 to $25,000 for each violation may be imposed.

Before the year ends and you prepare those 1099-MISC forms, it would be prudent to evaluate your vendors to determine if you have any possible misclassified individuals. Seeking advice on this topic could save you from some very punitive consequences.

Pursuant to IRS Circular 230, the Internal Revenue Service requires us to inform you that any tax advice included herein is not intended or written to be used, and it cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed by the IRS on the taxpayer. That said, please do not hesitate to contact us if you have any further questions regarding this matter.

Tags: Form 1099, Independent Contractor, Payroll