Worker Misclassification: When your peeps are really YOUR peeps

January 17, 2013.  Editor’s Note: Today we welcome a guest post from TechDrawl contributor Cindy Grossman, a partner at Giordani Swanger Ripp & Phillips LLP in Austin.  Cindy specializes in business transactions, particularly with respect to tax implications.  This is a bonus edition of TechDrawl, about twice the normal length, but it’s a complex subject that deserves your attention if you are scaling up a technology company. Cindy does a great job of explaining the risks and how to mitigate those risks for those of us who are hiring employees and/or contractors and/or are not sure which.  In fact, the IRS may already be looking for us.  Read on:


TechDrawl recently passed along from @TriNet this link about classifying exempt vs. non-exempt employees:  It's a good post and hits at some very important issues relevant to any employer out there, so I recommend you take a look.

As I was reading that post, I thought about a case I recently worked on dealing with worker classification of a different sort: employees vs. independent contractors.  While this classification issue applies to all employers, it is particularly relevant to the technology industry due to the particular culture of that industry.  I'll explain what I mean by that in a bit...

First, a crash course in worker classification.  Generally speaking in the realm of tax, there are two categories of workers: employees and independent contractors (excluding business owners who are workers, of course). An employee's compensation income is reported on a W-2, which they receive from their employer. Their federal and state income taxes are withheld by the employer, and the employer pays one half of the employee's payroll taxes (FICA/FUTA), and the employee pays the other half (through withholding by the employer).

Independent contractors' compensation is reported on a Form 1099.  The independent contractor is responsible for payment of 100% of his payroll taxes, and no income tax or payroll tax is withheld by the employer.  At the end of the day, employers generally like independent contractors because the employer does not have to pay its share of the worker's payroll taxes, thus saving the employer some money. Some workers prefer to be independent contractors because they can deduct more business-related expenses than can a W-2 employee.

How do you tell an employee from an independent contractor? It's all about control. From the IRS's website:

“In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.

Facts that provide evidence of the degree of control and independence fall into three categories:

1.     Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?

2.     Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)

3.     Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.

The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.”

So you might be wondering why I singled out the tech industry in this post? Well, it turns out that this industry is a repeat offender in the realm of worker misclassification, and the IRS knows this.  There may be other reasons why this is the case, but there are two factors that I've seen that lead to this: (1) what I'll call "classification creep" and (2) developer/programmer demands.

Here's an example of "classification creep":  Hot Austin start-up needs developers to work on their app that helps users select a beer based on the hoodie the user is wearing ("Brews based on the hoodie you use!"). just needs someone to put something basic together for them, and it's really just a one-off app project.  They hire Joe Coder to do it. Joe works from his house, on his own equipment, on this one project, and he works on it any way he pleases.  His only direction from is to build an app that works the way they want it to, and that it be completed (relatively) on time. Joe has other clients, and he continues to work on their projects as well. Joe is clearly an independent contractor in this case.

The app is a tremendous success, and beer companies all over Texas are contacting to develop other similar products. The business grows, new products are dreamed up. Joe is tapped to provide the development work. He does so, although he's subject to a bit more supervision from's new product designer. He still works from home, and still uses his own equipment. However, the product designer is telling him to develop the new products in a specific way. It's no longer totally up to Joe. Joe has less time to work on other clients' work, so he isn't really soliciting new clients at the moment. Is he still an independent contractor? Maybe.

A year later, Joe is now working full time for He pulled his marketing listings advertising his services because he just doesn't have time to take on new clients. He has an office at, although he still has the freedom to work from home. The founders of actively seek his input into new product ideas and development. For all intents and purposes (and certainly the IRS's), Joe is likely an employee of the W-2 variety.

That, my friends, is classification creep.

Developer demands also drive worker classification, although to a lesser extent. Being the awesome hotbed of tech innovation that Austin is, you can't walk down the street without running into a developer. In fact, one just moved in next door to me. They're everywhere.  But, while they might be plentiful, most are spoken for. Developer shortage = developers calling the shots (although not necessarily in an obvious way). This particular issue is what led to my client winding up in the misclassification soup.  They had started by hiring developers through a tech recruiting agency. Those developers were all independent contractors at first. They had their own LLCs that were directly contracted with my client. After time, however, classification creep set in and they really looked more like employees, even though the client was still 1099ing them. The client wanted to move them over to employee status because she knew they were classified incorrectly, but that would require paying them less and therefore not being as competitive compensation-wise compared to what the developer could earn just making one-off apps for people (she felt she could justify higher IC compensation to her board, but not such high employee salaries, even though the dollars out would have been the same). Additionally, becoming employees meant that these workers could no longer dip into the much deeper pool of deductions available to the self-employed.  Needless to say, there was resistance on the part of these workers to converting to employee status. To make matters worse, my client's company didn't have any employee benefit plans to lure them in. She was very worried that if she required them to be employees, they would just leave.  So the company chugged along this way until the CEO just got too worried about it to ignore it any longer.

Here's a very important point: just because you hired your independent contractors via a recruiting agency, you are not off the hook.  You might even be paying them through the recruiting agency (you pay recruiting agency, recruiting agency pays contractor). Regardless of this arrangement, they still might be your employee, and if that's the case, you, not the recruiting agency, will be responsible for their employment taxes.

So what happens if you misclassify your workers? For starters, let me scare the pants off of you: starting back in 2011, the IRS embarked on a audit free-for-all whereby they are randomly auditing 6000 businesses for worker classification issues.  They're still doing it in 2013.

Ok, put your pants back on.  There is still hope for you if you think you've misclassified your workers. The IRS has three different programs to take some of the sting out of coming clean and properly classifying your workers (the sting being payment of ALL employment taxes you should have paid in past years, plus penalties and interest on those amounts).  Just warning you, it's going to get a little bit lawerly while I describe these programs.  If you want to skip the lawyerly stuff, here's the quick and dirty:

Section 530 relief = Holy Grail of audit relief. No taxpayer liability. Get it if you can. Eligibility requirements apply.

Classification Settlement Program = settle your audit and pay just 25% of one year employment tax liability. No penalties. Eligibility requirements apply.

Voluntary Classification Settlement Program = beat the IRS to it and come clean. Settle at 10% prior year's employment tax liability, no penalties or interest. Eligibility requirements apply.

Keep reading if you want the legal details on these programs...

The first program is the holy grail of employment misclassification relief: Section 530 relief. If a company is under audit and qualifies for Section 530 relief, the IRS may not assess any back employment taxes, penalties, or interest against the company, and the IRS cannot obligate the company to reclassify the workers in question on a go-forward basis.

To qualify for Section 530 relief:

1.     The company must have timely filed 1099’s for all workers at issue

2.     The company must have treated other workers holding substantially similar positions as independent contractors as well

3.     The company must have a reasonable basis for treating the worker as an independent contractor

      Reasonable basis includes:

1.     Reliance on court decisions, published IRS rulings, private letter rulings for the specific company, or worker classification determination letters for the specific company (“SS-8s”);

2.     Past IRS audit in which no assessment attributable, for employment tax purposes, of workers holding positions substantially similar to workers at issue

3.     Recognized industry practice

4.     Some other “reasonable basis"

Note: Section 530 relief is not available for companies that offer recruiting or staffing services for technology workers such as software programmers.

If you don't qualify for Section 530 relief, not to worry.  The IRS also offers a Classification Settlement Program:

1.     CSP can be offered by IRS following denial of Sec. 530 relief in audit context

2.     If 1099s filed timely, and substantive consistency in treatment of workers, taxpayer may pay 25% of one year of employment tax liability, determined under reduced rates in Section 3509 (10.28% up to the social security wage base, and 3.24% for amounts above).

3.     Terminates audit risk for prior years for employment taxes

4.     Interest may be waived

5.     Penalties waived

6.     Not required to reclassify until quarter following acceptance of CSP offer

For most taxpayers, the CSP is likely a better alternative to fighting the issue in court. If the taxpayer loses in tax court, they're responsible for 3 years of back taxes, penalties and interest will apply; they will also face steep attorney fees.

If your misclassification issues are keeping you up at night, but you haven't yet gotten the knock on the door from your friendly IRS agent, the IRS also offers a Voluntary Classification Settlement Program to ease your troubled mind.


1.     If 1099s have been filed timely, the taxpayer is not currently under employment tax audit, and taxpayer has consistently treated non-employee workers in the past, taxpayer may pay 10% of prior year’s employment tax liability, determined under reduced rates in Section 3509 (10.28% up to the social security wage base, and 3.24% for amounts above – roughly 1% of wages).

2.     Penalties and interest are waived.

3.     Currently, there is some temporary expansion of eligibility for employers who might not have filed all of those pesky 1099s.

4.     Additionaly, the IRS has done away with the requirement that the employer extend the statute of limitations upon signing of the closing agreement.

5.     Immediate reclassification of workers upon acceptance of settlement offer

So now you have the relevant information on worker classification and how to get out of the soup if you've done it wrong. If you're worried about your status, or you've been contacted by IRS, call a knowledgeable tax attorney who can walk you through your options.


Thanks to Cindy Grossman (@CLGesq) for this fine post.  If you’re afoul of the IRS rules, I think the only potential cure she didn’t cover is getting an interview with Oprah.