All businesses that hire employees are required to pay employment taxes to the IRS. These consist of two separate taxes:
Employers are required to withhold half of the Social Security and Medicare taxes from their employees' paychecks and pay the other half out of their own pockets. The money is supposed to be sent to the IRS or an authorized financial institution, usually monthly or semi-weekly. Employers must report employment taxes withheld from their employees on Form 941, Employer's Quarterly Federal Tax Return.
Unfortunately, some employers attempt to evade their employment tax responsibilities. There are many reasons for this. Some cash-starved businesses try to use the IRS as a bank—they withhold the employment taxes from their employee's paychecks and then "borrow" the money for a short with the intent to pay it back later. Others simply take the money with no plan ever to repay it. Some employers are misguided "tax protesters" who mistakenly believe that all federal taxes are unconstitutional.
As far as the IRS is concerned, whatever the reason, not paying employment taxes is just about the worst thing a business can do. Former IRS Commissioner Mark W. Everson said that "failure to pay employment taxes is stealing from the employees of the business." Employers who engage in this practice face harsh civil and criminal penalties, including jail time.
Employment tax evasion schemes can take many forms. The IRS says that some of the more common include pyramiding, misclassifying workers as independent contractors, paying employees in cash, filing false payroll tax returns, or failing to file payroll tax returns.
Pyramiding of employment taxes is simple theft. The business withholds taxes from its employees' paychecks, but intentionally fails to pay them to the IRS. Businesses involved in pyramiding frequently file for bankruptcy to avoid having to pay their creditors. Then they start a new business under a different name and begin a new scheme.
Paying employees in cash is a long-used and common method of evading income and employment taxes. It is not illegal for a business to pay an employee in cash, but employment taxes are still owed on the payments. With no paper-trail, it is difficult, if not impossible, for the IRS to discover that a business is evading its employment tax responsibilities.
Employment taxes only need be withheld and paid for the employees a business hires, not for independent contractors. So one common method of avoiding these taxes is to improperly classify a worker as an independent contractor instead of an employee. The basic rule is that if the hiring firm has the right to control what work will be done and how it will be done, the worker is an employee. Employers who misclassify employees as independent contractors are liable for the employment taxes that should have been paid on their wages and are subject to substantial penalties. For more details on how to classify workers, see "Independent Contractor or Employee: How Government Agencies Make the Call."
Another way businesses evade employment taxes is to prepare false payroll tax returns understating the amount of wages on which taxes are owed. Other businesses fail to file any employment tax returns at all.
The IRS strongly encourages employees to report any concerns they have that their employer is failing to properly withhold and pay federal income and employment taxes. You can call the IRS at 800-829-1040 or report suspected tax fraud by calling 800-829-0433.