Given that the IRS' system for classifying workers is imprecise at best, what happens if someone is misclassified? According to Satuloff, business owners, not independent contractors, face the greatest exposure. The important thing to remember is that whichever classification you use, you need to apply it consistently.
If the IRS decides you used the wrong classification--and this usually means a person you classified as an independent contractor is really an employee--for each person misclassified, your company is liable for back taxes plus any accrued interest and penalties. Worse yet, if the IRS determines your misclassification was "willful," you'll be assessed additional penalties-and you run the risk that the IRS will choose to go back to any open years and examine your tax returns to see if a pattern exists.
According to Kaplan, it's dangerous to treat someone as an independent contractor and not follow through by filing a Form 1099, which indicates payments to vendors. "This is the form that leads the IRS from the business back to the independent contractor to see if there's compliance," he says.
More bad news for business owners, says Jill Jachera, a partner at Klehr Harrison, is that there are other legal ramifications if you classify someone as independent and the IRS reclassifies him or her as an employee. For instance, certain laws go into effect based on the number of people you employ. The Family and Medical Leave Act kicks in when you have 50 employees, and the Americans With Disabilities Act applies when you have 15 employees. Complying with either of these can add additional expenses in the form of benefits and capital improvements.