Contractor Misclassification in Due Diligence: Fix Before Close?

Contractor misclassification in due diligence: what is at stake for the round?

The federal exposure is usually back employment tax on what the workers were paid, figured at reduced section 3509 rates, plus penalties and interest. The company owes the full employer share of Social Security and Medicare, plus a fraction of the employee share and a small percentage of wages in place of income tax withholding, and it cannot recover any of that from the workers. State unemployment tax, state withholding and wage claims can add more.

A misclassification finding need not stop a round by itself. Investors usually ask for three things: the workers on payroll going forward, a sized estimate of the past, and the item listed on the disclosure schedule. What makes a case harder:

• No 1099s were filed. The section 3509 rates for the employee share and for income tax double, and the IRS settlement program is not available.
• Founders or officers were paid on invoices. An officer who works and is paid is generally an employee.
• Options were granted to the workers as ISOs. ISO status depends on employee status.
• Workers in several states, or abroad. Each state applies its own test.
• Deliberate avoidance. Section 3509 rates do not apply when the employer intentionally disregarded the duty to withhold.

Whether each worker is in fact an employee is decided under the IRS common-law test; see contractors who may be employees.

How do we size the back federal payroll tax under section 3509?

Multiply each worker's pay for each open year by the section 3509 rates that fit that worker. The rate depends on whether the company filed the required Forms 1099 for that worker (section 3509(b); Form 941-X instructions).

A year is open if the IRS can still assess it. That is generally three years after the Forms 941 for the year are treated as filed, which is April 15 of the next year when they were filed on time. For a quarter with no Form 941 filed, there is no time limit (26 U.S.C. 6501).

With 1099s filed, the IRS puts the combined rate at 10.68% of pay up to the Social Security wage base of $184,500, and 3.24% above it (VCSP FAQ). Federal unemployment tax (FUTA) is added on the first $7,000 per worker each year.

Section 3509 rates do not apply if the company intentionally disregarded withholding, withheld income tax but not Social Security and Medicare, or for certain statutory employees. Late deposits can draw penalties of 2% to 15% of the unpaid deposit, and interest runs on unpaid tax (IRS: deposit penalty).

The correction itself goes on Form 941-X, lines 19 to 22, with line 42 checked and an explanation on line 43. If the company never filed Form 941 because everyone was a contractor, it files a Form 941 for each missed quarter marked "Misclassified Employees" with a Form 941-X attached (Form 941-X instructions). The sibling guide covers the mechanics of each past return.

What do California's ABC test and other state tests add?

A state can treat the same worker as an employee even where the federal answer is unclear. California presumes a worker is an employee unless the company shows all three parts of the ABC test (California EDD; California Labor and Workforce Development Agency):

1. The worker is free from the company's control and direction, under the contract and in fact.
2. The work is outside the usual course of the company's business.
3. The worker is customarily engaged in an independent trade or business of the same kind.

Part 2 is the hard one for a startup: an engineer writing the product's code is doing the company's usual business. California uses a different multifactor test for listed exceptions. A finding there can bring back state unemployment insurance, disability insurance, training tax and state withholding.

Other states use their own tests, and some differ between unemployment insurance and wage laws. Check each state where a worker lives or works; see employees in another state. Unpaid overtime, benefits and other wage-and-hour claims are an employment lawyer's work.

Do we convert contractors to employees before the funding closes or after?

The tax rules set no closing deadline; the choice is about timing and which relief stays open. Two common paths:

Either way, the round usually closes with the past sized and listed, not settled. Moving workers to payroll means new accounts and withholding; see setting up payroll.

Does converting now rule out the Voluntary Classification Settlement Program?

Yes, for those workers. The program requires the company to be presently treating the workers as nonemployees when it applies, and to have filed all required Forms 1099 for them for the prior three years, or for as long as they worked if shorter (Form 8952 instructions). Once some workers in a class are reclassified, every worker in that class must be (VCSP FAQ). A 1099 filed within 6 months of its due date still counts.

In exchange, the company pays 10% of the section 3509 tax on the most recent completed year's pay only, with no interest or penalties and no employment tax audit of those workers' status for prior years. Signing makes no admission about prior years. The IRS recommends filing Form 8952 at least 120 days before the date employee treatment begins; this is a recommendation, not a deadline (IRS: VCSP; VCSP FAQ).

The company cannot apply while under an IRS employment tax audit or a labor or state agency classification audit. The program settles federal employment tax only, not state tax or wage claims. The IRS says it does not share applications with the Department of Labor or state agencies.

Founders and officers paid as contractors: are they employees?

Usually yes. An officer of a corporation is generally an employee for federal employment tax; the exception is an officer who performs no or only minor services and neither receives nor is entitled to pay (Publication 15-A). A director is not an employee for services as a director.

A founder-officer paid on invoices is therefore usually receiving wages, and payroll should start for that founder. Whether section 3509 rates apply to the past depends on whether the withholding was intentionally disregarded, which is fact-dependent. Separately, a person responsible for withholding who willfully fails to collect or pay it over can be personally liable for a penalty equal to the tax not collected (26 U.S.C. 6672). For setting pay after the raise, see founder salary in a venture-backed corporation.

Options granted to contractors: are they still ISOs?

An incentive stock option (ISO) can only be granted to an employee of the company or a related corporation (26 U.S.C. 422). Employee status for this rule follows the same common-law test as withholding (26 CFR 1.421-1(h)).

The second row turns on the same facts as the payroll question, so the company's records should take one consistent position. The holder must also stay an employee until three months before exercise. Fix the option ledger and any Form 3921 filed for a grant that is not an ISO, and report any exercise of it as an NSO; see granting stock options after a valuation.

What goes in the books and on the disclosure schedule?

The books carry the sized estimate of back tax, penalties and interest, as a recorded liability or a note, whichever the company's accountant and auditors conclude the accounting rules require. The disclosure schedule lists the classification item as an exception to the payroll and employment tax reps, with the workers, years and status of any fix.

Counsel drafts the schedule; the tax inputs are the estimate, the filings made and any Form 8952 or Form 941-X. See tax representations and the disclosure schedule for the rest of the reps.

What records do we gather?

Gather the records that size the estimate and support the facts:

• Each worker's contract, offer letter and statement of work
• Payments by worker, month and year, and how they were paid
• Forms 1099 filed, with filing dates; see late contractor and employee tax forms if any were missed
• Each worker's title, duties, hours, equipment and who directed the work
• Where each worker lives and works, by period
• Option grants, board approvals and any Forms 3921
• Any Forms 941, 940 and state payroll returns already filed
• Any IRS, labor or state agency letters about worker status

Example

These examples are illustrative; figures are in US dollars.

Three engineers on 1099s for two years

A Delaware C corporation paid three engineers $100,000 a year each for two years: $600,000 in all. Every 1099 was filed.

• Section 3509 rates with 1099s: $600,000 × 10.68% ≈ $64,000 of federal back tax.
• Without 1099s, the rates rise to 8.68% + 2.03% + 3% = 13.71%: about $82,000.
• Penalties, interest, FUTA and state tax come on top.
• If the company applies to the settlement program before converting, the payment is 10% of the section 3509 tax on the most recent year's $300,000: about $3,200.

Founder paid as a contractor

The CEO of the C corporation took $8,000 a month on invoices. As an officer who works and is paid, the CEO is generally an employee. Payroll for the CEO starts before closing, and the past pay is sized with the other workers.

Options to a contractor labeled ISO

A contractor who builds marketing sites for several clients received an option labeled ISO. A true contractor cannot hold an ISO, so the grant is treated as an NSO; the company corrects the option ledger and any Form 3921.

Different for you?

• You are not sure the workers are employees at all: apply the IRS test and look at section 530 relief in contractors who may be employees.
• Other tax items also turned up in diligence: see tax clean-up before investor due diligence and get startup tax help.
• Some workers are outside the US: see hiring employees abroad for a US startup.
• Workers are in several states: see employees in another state.
• Contractor 1099s were never filed: see late contractor and employee tax forms.
• Founders need salaries after the round: see founder salary in a venture-backed corporation.
• The fix touches the closing documents: see tax representations and the disclosure schedule and get startup tax help.