Employee or Independent Contractor? New Jersey Business Taxpayers Can Correct the Misclassification of Workers with Minimal Tax Liability

April 8, 2012

Businesses with any New Jersey employees are responsible for withholding and paying income taxes, Medicare taxes, and Social Security, and paying payroll taxes on wages paid to their employees. However, in general, the same businesses do not have to do so when hiring independent contractors.

Therefore, it may be tempting for a business to classify all workers as independent contractors to avoid payments. However, the Internal Revenue Service and New Jersey Division of Taxation have stringent regulations to ensure that businesses correctly classify their workers. The IRS imposes significant penalties on businesses which have misclassified their workers as independent contractors.

A worker is an independent contractor if the "employer" has the right to direct only the result, but not the way in which the worker performs her job. For example, if a business hires a New Jersey attorney to sue another company for breach of a contract, the business does not direct the attorney on how to argue the case, what motions to file, etc. The client educates the attorney about the dispute and asks the attorney to work towards a certain result (recovering lost profits). Therefore, this attorney is a New Jersey independent contractor, not an employee.

Likewise, when a homeowner hires a contractor to construct a house, the homeowner does not tell the contractor how many planks to use or how to obtain the proper building permits. The homeowner asks only that a building be constructed to meet the homeowner's needs; the method in which the contractor meets those needs is up to the contractor.

Under the law in New Jersey independent contractors must pay taxes the same way a self-employed workers would. However, it is important to keep in mind that in very limited circumstances, New Jersey independent contractors may still be taxed as employees, such as with traveling salespersons.

On the other hand, if the hiring party has the right to control and direct exactly what the worker does, the scope of her job, and how she performs and completes the job, then the worker is an employee and must be classified as one on the employer's taxes. Even when a worker is allowed a certain amount of freedom in performing her job duties, if the employer has the right to control the worker's actions, whether or not the employer actually exercises that right, the worker is an employee, and the employer must pay payroll taxes.

Although the Internal Revenue Code contains penalties for employers who misclassify workers, the IRS distinguishes between innocent mistakes and willful violations. However, if the employer's misclassification is found to have been willful, then additional penalties would be assessed against the employer, which could include criminal charges.

However, in an effort to get all businesses to correctly classify their workers, the IRS launched its Voluntary Worker Classification Settlement Program in September of 2011. This program allows New Jersey business taxpayers to voluntarily correct their past misclassifications at a lesser cost and avoid the larger penalties that would result from an audit. Eligible employers who opt into the program will owe only 10 percent of the tax liability that would have been due on the employees' wages over the past year, rather than the 20 percent of what should have been withheld, plus 1.5 percent of wages paid to the employee, which would have otherwise been due under the Internal Revenue Code. Under the program, no interest or penalties would be assessed. Also, because the disclosure is considered voluntary, the business would, in almost all cases, be able to avoid any potential criminal employment tax prosecution.

To be eligible for this program, the employer must (1) have consistently treated the workers as nonemployees in the past, (2) have filed all required 1099 forms for the workers for the past 3 years; and (3) not currently be under audit by the IRS, Department of Labor, or any state agency regarding the classification of workers. The employer must then file an application for the program at least sixty days before the business intends to start treating workers as employees. All the terms of the agreement between the business taxpayer and the IRS will be put in a written agreement.

A business may reclassify one or all of its workers. However, once the business reclassifies one worker as an employee, all individuals in the same position or class must be treated as employees.

Any business taxpayer concerned about whether it has misclassified employees as independent contractors should seek legal counsel as soon as possible to take advantage of this Settlement Program. Although the IRS has not yet set an expiration date on the effect of this program, businesses should not wait for such a date to be set to take advantage of this program.

The attorneys at McLaughlin & Nardi are experienced with aiding New Jersey businesses in both employment and tax matters. Our attorneys represent businesses in audits by the federal and New Jersey tax authorities and labor departments regarding the classification of employees, and in challenges to the classification of employees. Indeed, one of the firm's partners is also a certified public accountant with extensive experience with and knowledge of tax law. To learn more about what we can do to help, please visit our website or contact one of our lawyers by e-mail or call (973) 890-0004