Here is a sentence from the IRS's own Construction Industry Audit Technique Guide: "Many taxpayers treat employees as subcontractors to avoid paying employment taxes." That is how examiners are trained to think about your crew list before they ever meet you.
Plenty of construction workers really are independent contractors. Plenty are not. The difference is not what the paperwork says. It is how the work actually happens, and when the IRS gets it wrong in your favor or you get it wrong in theirs, the money moves fast.
The test is common law control
For federal employment taxes, IRC 3121(d)(2) defines an employee as any individual who, under the usual common law rules for determining the employer-employee relationship, has the status of an employee. There is no magic in a 1099, an LLC or a signed independent contractor agreement. The question is control: who decides how, when and where the work gets done.
The IRS's guidance on independent contractors groups the evidence into three categories and says to look at the entire relationship and the extent of the right to direct and control the worker:
- Behavioral control. Does the company control, or have the right to control, what the worker does and how the worker does the job? A foreman who directs how the framing gets done, not just whether it passes inspection, is behavioral control.
- Financial control. Are the business aspects of the job controlled by the payer? The IRS points to how the worker is paid, whether expenses are reimbursed and who supplies the tools and materials. Hourly pay with your tools and your materials looks like employment. A bid price for a defined scope, with the sub's own equipment, looks like a business.
- Type of relationship. Is there a written contract, are there employee-type benefits, will the relationship continue, and is the work a key part of your business? A carpenter who has worked only for you for six years, doing the core work of your company, is hard to call a vendor.
No single factor decides it, and the IRS says the business should document each factor it considers. Write the analysis down while the facts are fresh, not after the examiner asks.
Either the business or the worker can ask the IRS to decide. Form SS-8 is used by firms and workers to request a determination of whether a worker is an employee or an independent contractor for federal employment tax and income tax withholding purposes. Be careful filing one in the middle of a dispute. You are asking the IRS to look.
What reclassification costs: IRC 3509
When an employer fails to withhold because it treated an employee as a nonemployee, IRC 3509 often sets the employer's liability at reduced rates instead of the full amounts the employee should have had withheld:
| Situation | Income tax withholding liability | Employee share of FICA |
|---|---|---|
| You filed the required Forms 1099 (section 3509(a)) | 1.5 percent of wages | 20 percent of the employee FICA amount |
| You failed to meet the reporting requirements without reasonable cause (section 3509(b)) | 3 percent of wages | 40 percent of the employee FICA amount |
Section 3509 only reduces the withholding-type amounts listed above. The employer's own share of FICA under IRC 3111 is a separate tax on the employer and is not discounted by section 3509.
Three rules in section 3509 matter a lot:
- Filing the 1099s cuts the rates in half. The reduced rates in section 3509(a) double under section 3509(b) if you failed to meet the information reporting requirements of IRC 6041(a), 6041A or 6051 without reasonable cause.
- Intentional disregard kills the discount. Under section 3509(c), the reduced rates do not apply if the liability is due to the employer's intentional disregard of the withholding requirement. Then you are looking at full liability.
- You cannot pass the bill to the worker. Section 3509(d)(1)(B) says the employer is not entitled to recover from the employee any tax determined under the section.
Here is why the 1099 matters so much in this industry. The Audit Technique Guide says some contractors work for less on condition that no 1099 is issued, and the reverse is true on the payment side: some contractors pay crews in cash with no paperwork. That second group lands in section 3509(b) at best and full liability at worst. We cover the reporting side in our guide to 1099 and backup withholding penalties.
Section 530 relief
There is a defense that is not even in the Internal Revenue Code. Section 530 of the Revenue Act of 1978 can relieve a business of federal employment tax liability for workers it treated as independent contractors. The IRS's guidance on worker reclassification notes that section 530 is not part of the Code, though some publishers print its text after IRC 3401.
According to the IRS, all three of these must be met:
- Reporting consistency. You timely filed the required information returns, such as Forms 1099, consistent with treating the worker as a non-employee.
- Substantive consistency. You did not treat the worker, or any worker in a substantially similar position, as an employee after 1977.
- Reasonable basis. You reasonably relied on judicial precedent, a prior IRS audit of the same or a substantially similar class of workers, or a long-standing recognized practice of a significant segment of your industry, or some other reasonable basis.
Substantive consistency is where many contractors lose this defense. If you have two framers on W-2 and six on 1099 doing the same work, you have a problem. Industry practice is the safe harbor construction companies argue most, and it needs evidence, not a general statement that everyone in the trade does it.
The Voluntary Classification Settlement Program
If you already know some of your 1099 workers should be employees, the IRS offers a way to fix it going forward at a reduced cost. Under the Voluntary Classification Settlement Program, as described on the IRS's VCSP page:
- You must currently treat the workers as nonemployees and want to treat them as employees going forward.
- You must have filed all required Forms 1099 for those workers for the previous three years.
- You cannot be under an employment tax audit by the IRS, or a Department of Labor or state audit concerning classification of the workers.
- You pay 10 percent of the employment tax liability that would have been due on compensation for the most recent tax year, computed under the reduced rates of IRC 3509(a), with no interest or penalties.
- You are not audited on employment taxes for those workers for prior years.
- You apply on Form 8952 at least 120 days before the date you want to begin treating the workers as employees, and the taxpayer must sign it personally.
The catch for many contractors is the 1099 requirement. If you paid crews without 1099s, VCSP is not available for those workers.
The unpaid bill becomes a collection problem
A reclassification assessment is an employment tax liability. If the business cannot pay it, collection can reach your receivables and, in some cases, the individuals responsible for paying over withheld taxes. Collection against receivables is covered in our guide to levies on contractor receivables. For the broader employment tax picture, see the firm's payroll tax page.
What to do now
- List every 1099 worker and write down, honestly, how each one works for you.
- Collect Forms W-9 and file every required 1099, every year, on time.
- Look for inconsistency: workers doing the same job on different forms.
- If you have a reasonable basis for contractor treatment, document it now, with the precedent, prior audit or industry evidence.
- If you do not, consider whether VCSP makes sense before an examiner makes the decision for you.
The same analysis applies in trucking, where drivers are often paid as contractors; see our guide to owner-operator classification.
A 1099 is not a classification. It is a claim. Make sure the facts back it up.