The Employee vs. Contractor Issue
This is one of the most EXPENSIVE mistakes you can make - treating an employee as an independent contractor.
What happens if the IRS determines that an independent contractor is really an employee? They will access the unpaid payroll taxes using this formula:
Total the annual payments to the misclassified employees and multiply that number by 13.71%. This is the equivalent of the social security taxes plus the income taxes that should have been withheld
Add the Failure-to-Pay Penalty which will max out at 25% of the total tax
Add an additional penalty of $50 for any unfiled W-2's
This totals to more than $17,000 dollars of taxes and penalties for each $100,000 of misclassified payments. And, they will do this calculation for any open tax year, which is usually 3 years.
My Advise: When in doubt - treat them as an employee
Note: You can ask the IRS for a determination on the correct worker status by submitting a Form SS-8
What to do if the IRS brings up this issue
Your first best bet is to make the best argument and evidence that you can muster to show that under the 20 Common Law Tests the preponderance of the factors are in your favor. If you can build a moderately reasonable case, be willing to take the issue to Appeals. The Appeals Division has more flexibility when it comes to making agreements.
The IRS has a relief program called Section 530 Relief that can help. Section 530 is a safe harbor provision that prevents the IRS from retroactively reclassifying "independent contractors" as employees. Relief is available to taxpayers under audit or involved in administrative or judicial proceedings with respect employment status reclassification.
In order to qualify for 530 relief, the taxpayer must have:
have consistently have treated the workers in the past as nonemployees;
have filed all required Forms 1099 for the workers for the previous three years; and
not currently be under audit by the IRS, the Department of Labor or a state agency concerning the classification of these workers.