For business owners, individuals who work for or in the business are either independent contractors or employees, one or the other. While the rules can be somewhat complex and fall in gray areas, the risks of misclassifying a worker are not. The Internal Revenue Service and state and local governments can make it painful for businesses and their owners that misclassify workers.
The IRS is on the lookout for companies that may exploit the worker relationship. It can be tempting for an employer to do so because of all of the associated employee costs:
Social security taxes
Medicare taxes
Unemployment insurance taxes
Workers compensation taxes
Overtime costs
Retirement benefit costs
Other benefits offered to employees
Government entities will usually check independent contractor vs. employee compliance during all routine IRS, Department of Labor, and state and local examinations. They will look at it during income tax audits, payroll tax audits, sales tax audits, as well as if there has been a report of abuse. If problems are found, a business could be required to pay back withholding taxes for the misclassified employees, including penalties, and interest. In addition, the business, and possibly company owners personally, could be sued for penalties and unpaid benefits or even criminally prosecuted.
In early 2010, the IRS issued rules defining the process and authority for IRS agents to step in and prepare employment tax returns in worker classification cases where they deem a company has misclassified a worker. Bottom line, this issue is front and center of the IRS plan to increase tax compliance.
Many companies are not clear on the difference between independent contractors and employees. The rules can be vague and every situation different. The rules are based on broad guidelines that measure the degree of control and independence a worker has with the business that hires them.
The best guidelines to assist in defining a relationship are the common-law rules published by the IRS. They define control and independence using three categories: behavioral control, financial control, and the type of relationship present.
Behavioral Control
Does the business control how the worker does the work? The more the business controls the specific details of the work, the more likely the worker is an employee.
Some important considerations:
Does the business provide specific instructions to the individual?
When and where work is preformed
What tools and equipment to use
What workers to hire and assist with the work
Where to purchase supplies and other services
Who is required to do what work
In what order the work is to be done
The key consideration is whether the business has retained the right to control the details of a workers performance
Training – Employees are generally trained on how to do the work; independent contractors usually use their own methods
Financial Control
Does the business have a right to control the business aspects of the job, such as:
The extent the worker has unreimbursed business expenses
The extent of the worker's investment in their craft
The extent to which the worker seeks to perform services for other businesses
How the business pays the worker
The extent to which the worker can realize a profit or loss
The more financial control the business has over the worker, the more likely the worker is an employee. The more financial independence the worker has from the business, the more likely the worker is an independent contractor.
Type of Relationship
Some other relevant questions that go into the mix:
Is there a written contract describing the relationship the parties intended to create?
Does the business provide employee-type benefits such as health insurance, retirement plan, vacation or sick pay?
How permanent is the relationship? If it is just for a specific time or project, it is likely to be an independent contractor relationship.
How much of a key aspect are the worker's services to the regular business of the company? The more key they are, the more likely it is an employee relationship.
In addition, industry standards can contribute in the determination of a worker's status. How do other companies in your industry treat certain types of workers?
Classification of a worker can be sometimes puzzling and complex. Some factors in a single situation may point to an employee relationship, others to an independent contractor. The most important key is to look at all the facts and circumstances, and determine the overall level or degree of the right the business has to direct and control the worker. By understanding the concepts of the common-law factors above, a business owner can avoid the pitfalls of misclassification. It simply does not pay to take the risk of making a mistake!
