Recently, in response the soaring United States deficit, the IRS has intensified its efforts to close the “tax gap” – the difference between the amount of taxes that would be collected if all taxpayers completely complied with tax laws and what the IRS actually collects. One way the IRS seeks to shrink this gap is by increasing audits on both large and small business to identify employees that have been misclassified as independent contractors.

The determination of whether a worker is an employee or independent contractor is an important one for businesses, because they generally do not have to withhold federal income taxes or FICA from the wages of independent contractors, as opposed to the wages of employees. In addition, businesses are not obligated to make FICA payments on the wages of independent contractors, while they do have such an obligation in relation to employees’ wages. For this reason, if the IRS was to discover that a business misclassified its employees as independent contractors, whether or not it was done intentionally, the result could be a substantial tax liability for the business, including interest and penalties.

However, there hope is for businesses that have misclassified their employees. Under Section 530 of the Revenue Act of 1978, an employer is completely relieved of its potential liability for the misclassification of employees if: (1) it filed all forms 1099-MISC on a timely basis, consistent with the employer’s treatment of the alleged employees as independent contractors; (2) the treatment of the worker in question as an independent contractor was consistent with the treatment by the employer of all similarly situated workers; and (3) it had a reasonable basis for treating such worker as an independent contractor.

Even if relief under Section 530 is not available, the employer’s liability for unpaid employment taxes may be subject to reduced rates under Section 3509 of the Internal Revenue Code and the employer may be eligible to receive credits against its liability for self-employment taxes actually paid by the workers in question.