The Covid-19 pandemic contributed to the highest unemployment rate since the Bureau of Labor Statistics began collecting unemployment data in 1948, with a high of 14.8% in April 2020 Unemployment Insurance Program launched August, 1935. To fund the program, employers pay annual or quarterly federal unemployment taxes, which are used to support unemployment benefit payments to workers who have lost their jobs. Soaring unemployment has put the program's limits to the test, raising awareness of a growing problem in the US: the lack of occupational health and safety afforded to the expanding gig economy workforce.
Gig workers are independent contractors who enter into a formal agreement with on-demand companies. The Bureau of Labor Statistics reported in 2017 that up to 55 million people were gig workers in the United States. This demographic now makes up about 34% of the U.S. workforce and is projected to grow to 43% in 2020.
Because they don't pay federal unemployment tax (FUTA), freelancers, independent contractors, gig workers, and other self-employed workers are usually not eligible for unemployment benefits. Without the CARES bill, which extends unemployment benefits to independent contractors in 2020, gig workers would have had nowhere to find financial support during the pandemic. While companies providing platforms for gig workers have been financially successful during the pandemic, W-2 taxpayers will ultimately have to fund the unemployment benefits granted to independent contractors under the CARES Act.
The Biden government is aware of the lack of labor protection for gig workers and the tax loopholes of the gig economy. April 2021, Labor Secretary Marty Walsh said in an interview with Reuters: “The department is investigating many cases where gig workers should be classified as employees. The department will be holding talks with companies employing Gig Lab over the coming months to ensure workers have access to constant wages, sick leave, health care, and all the things the average worker in America can access. Federal withholding taxes account for nearly 70% of all federal tax revenue paid to the IRS. It is likely that Treasury Secretary Janet Yellen will follow Secretary Walsh's lead in investigating employee misclassification in order to raise funds for employee benefits and the $ 6 trillion aid package proposed by President Joe Biden.
Incorrect classification of employees for tax purposes
A growing number of companies have succeeded in reducing costs by mistakenly classifying regular employees as independent contractors. Gig economy companies market gig worker jobs as entrepreneurial opportunities rather than traditional employment. These workers are often given the same training, jobs and tasks as regular workers, but not the same benefits such as minimum wages, overtime pay, unemployment insurance, health care and workers' compensation.
Independent contractor misclassification occurs when an employee who should have been given a W-2 tax form to file their tax return instead receives a 1099 Other Income (MISC) form. Therefore, an employee whom the IRS is likely to consider a direct employee of a company is treated as a self-employed independent contractor. Companies prefer to classify workers as independent contractors in order to avoid various contractual obligations, thereby saving labor and administrative costs and ultimately gaining an edge over competitors.
The misclassification of independent contractors enables companies to avoid mandatory payroll taxes, including half the employer's pension insurance contribution and Medicare tax, which totaled 15.3% of gross wages in 2020. Additionally, these employers avoid paying state and federal unemployment insurance taxes because self-employed contractors are not considered employees and are therefore not covered by the unemployment insurance system.
Determining the correct classification of workers is not always clear. Employers must weigh all factors in determining whether an employee is an employee or an independent contractor. The IRS uses the following categories in deciding on the correct classification of workers:
- Behavioral control – type of instructions, level of instructions, staff training and evaluation system.
- Financial control – a right to direct or control the financial and business aspects of the work of the employee; Investments in workers' equipment, payment methods, ability to work for others, unreimbursed expenses.
- Types of relationships – written contracts, services, locksmithing and the duration of the relationship.
Penalties for incorrect classification
In the event of an unintentional misclassification, the employer faces at least the following penalties:
- $ 50 for each Form W-2 that the employer failed to submit for classifying an employee as an Independent Contractor (Tax Act Section 6721).
- Penalties totaling 1.5% of wages for non-withholding income tax, plus 40% of FICA (Social Security and Medicare) taxes not withheld by the employee and 100% of the corresponding FICA taxes by the employer should have paid. These penalties also accrue interest daily from the date they should have been deposited (Section 6672).
- A penalty for non-payment of taxes of 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability (section 6651).
Deliberately or fraudulently
If the IRS suspects fraud or willful misconduct, it may impose additional fines and penalties. The employer faces criminal penalties of up to $ 10,000 per misclassified employee and one year in prison (Section 7202). In addition, the withholding tax officer could also be made personally liable for unrecovered taxes (§ 6672).
Tax liability insurance is a risk reduction solution for companies with large workforces of independent contractors who fear that an IRS review will incorrectly classify employees as independent contractors. Tax insurance is intended to protect a taxpayer from financial losses if the insured tax risk or the insured tax situation is challenged by a tax authority. Financial losses covered by tax liability insurance include tax losses (including interest and penalties), defense costs, and any surcharges resulting from a successful tax assessment.
Tax insurance policies for misclassification decisions may be obtained prior to an audit by the audit. The insurance may cover international, US federal, and state income and employment taxes resulting from an adverse tax ruling. Tax insurance can be purchased to protect against tax burdens of $ 2.5 billion to $ 1.5 billion. Most tax policies have a term of seven years, although longer insurance periods are possible. A one-time premium payment costs between 2.5% -5.5% of the desired tax coverage. Insurance carriers also charge a one-time subscription fee of $ 30,000 to $ 50,000. Depending on the type of risk, the sum insured can also be subject to a deductible (similar to a deductible). The deductible is traditionally limited to part of the defense costs.
Companies that want to take out tax liability insurance for the misclassification of employees should first contact their tax advisor to obtain a memorandum or a written statement that the intended tax treatment is more likely to be successful if it is challenged by the competent tax authority. After obtaining a factual analysis and memorandum from a tax inspector, insurance brokers can obtain preliminary quotes for coverage. After the prospective insured has selected an insurer, the company delivers its due diligence on its employee classification for underwriting. After an underwriting call and negotiations between the parties about policy exclusions, the premium is paid and the policy is bound. The entire process of obtaining insurance cover takes one to two weeks.
This column does not necessarily represent the opinion of the Bureau of National Affairs, Inc. or its owners.
Information about the author
Matt Chodosh is Area Vice President – Transactional Risk Products at Arthur J. Gallagher & Co. He is a retired transactional and tax dispute attorney. He can be contacted at [email protected].
Matt Chodosh is Area Vice President – Transactional Risk Products at Arthur J. Gallagher & Co. He is a retired transactional and tax dispute attorney. Mr. Chodosh has extensive experience in tax law and has knowledge of partnership tax, corporate income tax, gift and inheritance tax, and individual federal income tax. Prior to joining Arthur J. Gallagher & Co., he worked for a Chicago-based law firm serving clients on tax disputes before the Internal Revenue Service and the Illinois Department of Revenue. Prior to this experience, Mr. Chodosh worked for several Big Four accounting firms. Mr. Chodosh holds a CPA, a Juris Doctor, and a Master of Law Taxation (LLM). He can be contacted at [email protected].
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