A Tale of Two Businesses: The Hidden Costs of Worker Misclassification
Monika Taylor

This week, the IRS released Rev. Proc. 2025-10, which sets out criteria to get out of trouble when a business incorrectly classifies and employee as a contractor instead.  We are reminded of the dangers.

 

Sarah and Tom’s Stories

Sarah and Tom both started successful small home repair businesses in Raleigh in 2020. Each hired five workers, paying them $75,000 annually. While Sarah meticulously filed 1099s for her contractors, Tom decided paperwork was unnecessary since "everyone knows they're contractors."

 

Sarah’s Story

Sarah’s business, Crawlspace Solutions, classified workers as independent contractors and filed all required 1099s. During a 2025 IRS audit, she demonstrated:

  • Consistent reporting through timely 1099 filings
  • A reasonable basis for contractor classification
  • No similar workers being treated as employees

Although the IRS disagreed with her classification, Section 530 relief (outlined in Rev. Proc. 2025-10) protected her from devastating penalties.

 

Tom’s Nightmare

Tom's business, Tech Plumbing Services, does not qualify for the Section 530 relief since he did not file forms 1099.  He is facing bankruptcy after a similar audit revealed:

 

The Cascading Penalties

  • Back payroll taxes (15.3%): $57,375 annually
  • Federal and state unemployment taxes: $7,500 annually
  • Information return penalties: $2,900 ($580 per worker)
  • Failure-to-deposit penalties: $8,606 (15% of unpaid taxes)
  • Interest compounding on all amounts

Three-Year Look-Back

With the IRS examining 2022–2024, Tom’s liabilities included:

  • Employment taxes and penalties: $172,125
  • Unemployment taxes: $22,500
  • Information return penalties: $8,700
  • Failure-to-deposit penalties: $25,818
  • Accumulated interest

Tom’s total exposure exceeds $250,000, not including state penalties or potential personal liability.

 

The New Landscape

The IRS has significantly updated its approach with Rev. Proc. 2025-10, which provides more detailed guidance on worker classification. Key changes include:

  • Enhanced focus on technical personnel classification
  • Stricter requirements for Section 530 relief
  • More detailed provisions for determining similar positions

This update signals possible increased IRS scrutiny of worker classification, particularly. 

 

The Bottom Line
Proper worker classification and timely filing of information returns are more than just good business practices—they’re critical for survival. The risks of noncompliance are simply too great to ignore.

It’s worth noting that worker classification issues extend beyond the IRS to include oversight from the Department of Labor. Stay informed and stay compliant!