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Employee Misclassification Too Big to Ignore

July 1, 2021, 8:00 AM

The Covid-19 pandemic contributed to the highest rate of unemployment since the Bureau of Labor Statistics began tracking unemployment data in 1948, with rates peaking at 14.8% in April 2020. To safeguard against poverty, Congress created the unemployment insurance program on Aug. 14, 1935. To fund the program, employers pay annual or quarterly federal unemployment taxes which are utilized to support unemployment compensation payments to workers who have lost their jobs. Skyrocketing unemployment has tested the program’s limits, and generated awareness, of a growing issue in the U.S.: the lack of labor protections afforded to the expanding “gig economy” workforce.

Gig workers are independent contractors who enter into a formal agreement with on-demand companies. The Bureau of Labor statistics reported in 2017 that as many as 55 million people in the U.S. were gig workers. This demographic now accounts for approximately 34% of the U.S. workforce and is projected to increase to 43% in 2020.

As they do not pay Federal Unemployment Tax (FUTA), freelancers, independent contractors, gig workers, and other self-employed individuals do not typically qualify for unemployment benefits. If not for the CARES Act extending Unemployment Assistance to independent contractors in 2020, gig workers would have had nowhere to turn for financial support during the pandemic. While companies that provide platforms for gig workers have financially prospered during the pandemic, W-2 taxpayers are ultimately left to fund unemployment assistance extended to independent contractors under the CARES Act.

The Biden administration is cognizant of the lack of labor protections afforded to gig workers and tax gaps left by the gig economy. On April 2, 2021, Labor Secretary Marty Walsh said during an interview with Reuters, “the department is looking into a lot of cases in which gig workers should be classified as employees. The department will have conversations with companies that employ gig labor in the coming months to make sure workers have access to consistent wages, sick time, health care and all of the things that an average employee in America can access.” Federal employment withholding taxes represent nearly 70% of all federal tax revenue paid to the IRS. It is likely that Treasury Secretary Janet Yellen will follow Secretary Walsh’s lead investigating employee misclassification in an effort to raise funds for worker benefits as well as President Joe Biden’s proposed $6 trillion relief package.

Employee Misclassification for Tax Purposes

A growing number of companies have managed to cut costs by misclassifying regular employees as independent contractors. Gig economy companies market jobs to gig workers as entrepreneurial opportunities instead of traditional employment. These workers are often provided identical training, workspaces, and assignments as regular employees but are not extended the same employee benefits, such as minimum wage, overtime pay, unemployment insurance, healthcare, and workers’ compensation.

Independent contractor misclassification occurs when a worker who should have received a W-2 tax form to file with tax returns instead receives a 1099-MISC (miscellaneous income) form. Thus, a worker whom the IRS likely considers a direct employee of a business is treated as a self-employed independent contractor. Businesses prefer to classify workers as independent contractors to avoid several employment-related obligations and thereby save on labor and administrative costs and ultimately gain an advantage over competitors.

Independent contractor misclassification enables businesses to avoid mandatory payroll taxes, including the employers’ half of the Social Security pension contribution and the Medicare tax, which totaled 15.3% of gross wages for 2020. In addition, these employers avoid paying both state and federal unemployment insurance taxes since independent contractors are not considered employees and thus not covered by the Unemployment Insurance system.

Determining the proper classification of workers is not always clear. Employers must weigh all factors when determining whether a worker is an employee or an independent contractor. The IRS utilizes the following categories when deciding the proper classification of workers:

  • Behavioral control—the type of instructions, degree of said instructions, worker training, and evaluation system.
  • Financial control—a right to direct or control the financial and business aspects of the worker’s job; investing in workers’ equipment, payment methods, ability to work for others, unreimbursed expenses.
  • Types of relationship—written contracts, benefits, key services, and the relationship permanency.

Penalties if Misclassified


If the misclassification was unintentional, the employer faces at a minimum the following penalties:

  • $50 for each Form W-2 that the employer failed to file because of classifying workers as an independent contractor (tax code Section 6721).
  • Penalties totaling 1.5% of the wages for the failure to withhold income taxes, plus 40% of the FICA taxes (Social Security and Medicare) that were not withheld from the employee and 100% of the matching FICA taxes the employer should have paid. Interest is also accrued on these penalties daily from the date they should have been deposited (Section 6672).
  • A Failure to Pay Taxes penalty equal to 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability (Section 6651).

Intentional or Fraudulent

If the IRS suspects fraud or intentional misconduct, it can impose additional fines and penalties. The employer could be subject to criminal penalties of up to $10,000 per misclassified worker and one year in prison (Section 7202). In addition, the person responsible for withholding taxes could also be held personally liable for any uncollected tax (Section 6672).


Tax liability insurance is a risk mitigation solution for companies with large independent contractor workforces fearful that an IRS audit will find employees misclassified as independent contractors. Tax insurance is designed to protect a taxpayer against financial losses suffered if the insured tax risk or position is challenged by a tax authority. Financial losses covered by tax liability insurance include tax losses (including interest and penalties), defense costs, and any gross-up arising from a successful tax assessment.

Tax insurance policies for misclassification rulings may be obtained prior to an audit investigation. Insurance may cover international, U.S. federal, and state income and employment taxes resulting from an adverse tax ruling. Tax insurance coverage can be obtained to protect against tax exposures from $2.5M to $1.5B. The term of most tax policies is seven years, though longer periods of coverage are available. A one-time premium payment costs between 2.5%-5.5% of the amount of tax coverage desired. Insurance carriers also charge a one-time underwriting fee of $30,000-$50,000. The insured amount may also be subject to a risk retention (similar to a deductible), dependent on the nature of the risk. The retention amount is traditionally limited to a portion of defense costs.

Companies interested in pursuing tax liability insurance for worker misclassification should first reach out to their tax adviser to obtain a memorandum or written opinion that the desired tax treatment is more likely than not to succeed if challenged by the relevant tax authority. Once a factual analysis and memorandum from a tax expert is obtained, insurance brokers may obtain preliminary quotations for coverage. After the prospective insured selects an insurer, the company turns over its due diligence related to its employee classification for underwriting. Following an underwriting call and negotiations between the parties regarding policy exclusions, the premium is paid and the policy is bound. The entire process to obtain insurance coverage takes one to two weeks.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Matt Chodosh is Area Vice President – Transactional Risk Products at Arthur J. Gallagher & Co. He is a former transactional and tax controversy attorney. He can be contacted at

Matt Chodosh is Area Vice President – Transactional Risk Products at Arthur J. Gallagher & Co. He is a former transactional and tax controversy attorney. Mr. Chodosh has extensive experience in tax law, and is knowledgeable in the areas of partnership tax, corporate tax, gift and estate tax, and individual federal income tax. Prior to joining Arthur J. Gallagher & Co., he worked for a Chicago-based law firm representing clients before the Internal Revenue Service and Illinois Department of Revenue on tax controversy matters. Preceding this experience, Mr. Chodosh worked for multiple Big Four accounting firms. Mr. Chodosh holds a CPA, Juris Doctor, and Master of Law Taxation (LLM). He can be contacted at

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