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Intentional Misclassification of Employees and the Trust Fund Recovery penalty

My blog on February 27th, explained the distinction between employees and independent contractors while providing some basic information about the trust fund recovery penalty.  This blog examines the intentional misclassification of employees and its consequences, as well as the operation and assessment of the trust fund tax penalty.  Employee misclassification is an enormous problem nationwide.  A 2012 list of state audits compiled by the National Employment Law Project estimates that the number of misclassified employees in the United States runs into the millions (with nearly 1.2 million such employees working in the two states of Pennsylvania and New York alone!).

The IRS has issued consumer alerts about fraudulent employment tax practices.  Notable among these are the withholding of employment taxes that are not thereafter submitted to the IRS, and paying employees wholly or partially in cash without assessing employment taxes.  These and other practices, such as using unreliable or outright criminal third-party payroll services, making frivolous or specious arguments about employee classifications advanced by unscrupulous promoters (a common–and illegal–tax resistance ploy, as noted elsewhere on this blog), or treating employee salaries as corporate distributions, offer strong evidence that an employer is trying to conceal losses or actively stealing money.  Such practices can trigger the application of a civil fraud penalty or a referral to the criminal investigative division.

For a taxpayer–in this case, the employer–to be guilty of fraud, he or she must have willfully attempted to not pay or underreport taxes.  An individual who has willfully attempted to misclassify employees is someone who has acted deliberately, knowingly, and with the specific intent to violate the law. If fraud or intentional misconduct or fraud is suspected, the IRS can impose additional fines and penalties; for example, penalties that include 20% of all the wages paid, plus 100% of the FICA taxes—both the employee and employer’s share.  IRS examiners will carefully scrutinize the employer’s business practices, looking for “badges of fraud” like the ones I have described here.  Individuals who are genuinely concerned about the classification of their workers–usually because they wish to classify them as independent contractors–can submit Form SS-8 and receive a prospective determination from the IRS, as discussed in my prior blog.

Criminal investigations for employment tax evasion have been an area of focus for the IRS, averaging about 120 cases a year with a 75% incarceration rate (18 months is the average sentence convicted parties are assigned to serve).  The Fiscal Policy Institute released a study in 2007 noting that the most egregious intentional misclassifications of employees occur in the delivery, trucking, building maintenance, janitorial, agricultural, home health care, and janitorial industries.  However, the rise of the “gig economy” and the emergence of alternative means of payment, such as Bitcoin, has surely altered that assessment.  At any rate, employers in these fields, or small business owners in general, would be well advised to consult with the IRS, a CPA, or a tax attorney if they are genuinely concerned about what their best practices should be.

In general, this entire area of taxation represents a minefield for the unwary.  Beyond concerns arising from outright fraud and other criminal activities, employers must understand the crucial distinction between trust fund-related and non-trust fund related taxes.  There are four types of employment taxes, with two classified as trust fund-related taxes and two as non-trust fund related taxes. The first two consist of the employee’s federal income taxes and the 50% share of Federal Insurance Contributions Act (“FICA”) taxes an employer is required to withhold from employee’s wages (these constitute the employee’s contributions to the Social Security and Medicare programs he or she will rely on during retirement). Non-trust fund taxes are those paid by the employer:  unemployment taxes, which the employee can redeem if he or she is laid off through no fault of his or her own, and the employer’s 50% contribution to the employee’s FICA taxes. The trust fund portion of the taxes can be assessed against the owners and responsible persons personally.

Given the amounts and types of money at stake, anybody who is responsible for payroll can wind up in significant trouble. In addition to imposing stiff penalties and interest on delinquent employment taxes, under Internal Revenue Code section 6672 the IRS can assert personal liability (i.e., the 100% trust fund recovery penalty that is triggered by intentional misclassification) for the trust fund portion of the delinquency on any and all of these “responsible persons.” Personal liability occurs regardless of the classification of the business (e.g. LLC, LLP, corporation, s-corporation). A responsible person could be anyone who has the power to ensure the trust fund taxes are paid on time, and may include middle managers, payroll supervisors, and comptrollers at the employee’s company as well as high-ranking officials at third-party payroll companies.

The IRS can assert and enforce personal liability for the trust fund portion against any number of responsible persons simultaneously and will likely try to hold as many persons as possible liable. Even filing for bankruptcy won’t eliminate or reduce this liability.  Moreover, the federal Department of Labor and many state departments of labor have also begun aggressively campaigning against misclassification of employees, with 27 states as of 2015 having passed “presumptive employee status” statutes that require employers to prove that their workers are truly independent contractors.

In sum, employers seeking to maintain workforces comprised of low-risk, low-cost independent contractors must tread carefully.  Federal and state governments, along with the IRS, have devoted considerable time and resources to ensuring that employers who are trying to exploit today’s fast-evolving economy must nevertheless comply with relevant labor and revenue laws.  For a phone consultation regarding the trust fund recovery penalty, payroll taxes, or other tax matters, please contact the Law Office of Aaron Richter, PLLC, a Reno-based law firm with expertise in Tax Controversy, Business Formation, Estate Planning, and Probate.