Worker misclassification and payroll tax liability

The IRS applies the common-law test, grouping evidence into behavioral control (do you direct how the work is done?), financial control (who invests in tools, who bears profit or loss, how they're paid) and relationship (written contracts, benefits, permanency, whether the work is a key part of your business). No single factor decides. Either party can request a determination on Form SS-8, though it takes months.

When an audit reclassifies workers, the business can owe federal income tax withholding, both halves of Social Security and Medicare, FUTA, penalties and interest. If the misclassification wasn't intentional disregard, IRC section 3509 imposes reduced rates instead of full liability — generally 1.5% of wages for income tax withholding and 20% of the employee's share of FICA (doubled to 3% and 40% if the business didn't file required Forms 1099). Intentional disregard removes those reduced rates.

Section 530 of the Revenue Act of 1978 can bar the IRS from reclassifying workers for employment tax purposes if the business had a reasonable basis (court rulings, a prior audit, or longstanding industry practice), consistently treated similar workers as contractors, and filed all required Forms 1099. It's a defense raised during an exam, not an application.

The VCSP lets eligible businesses start treating workers as employees prospectively. Eligible applicants pay 10% of the employment tax liability computed under section 3509's reduced rates for the most recent tax year, with no interest or penalties, and the IRS agrees not to audit prior years' classification of those workers. Requirements include having filed Forms 1099 for the workers for the prior three years and not currently being under an employment tax audit. Apply with Form 8952 at least 120 days before the planned start date.

States run their own unemployment and withholding classification tests, sometimes stricter than the IRS's. Reclassification can create state unemployment and withholding balances too — see state payroll withholding debt. Use the business assessment if an audit is already open.