Is your worker an employee or an independent contractor?
IRS still watchful for misclassified employees
The conflict between the IRS and businesses regarding who is an independent contractor and who is an actual employee is nothing new and will probably always be an issue. To keep your company as far from trouble as possible, get and keep yourself up to speed on the IRS rules regarding the use and classification of independent contractors.
In the traditional employer-employee relationship, the employer is responsible for a number of tasks. These include:
Withholding federal and state income taxes,
Paying unemployment taxes (FUTA),
Withholding the employee’s share of FICA and Medicare taxes, and
Paying both the employee and employer portions of FICA and Medicare taxes.
Independent contractors are responsible for their own taxes. In addition to making estimated tax payments for their federal and state income tax liabilities, they are subject to self-employment tax, which covers both the employer and employee shares of FICA. (They are, however, entitled to a deduction for the “employer’s” portion.)
Because it is easier and cheaper to collect taxes from a single employer than from multiple independent contractors, the IRS has a strong preference for employee status. If the IRS reclassifies independent contractors as employees, it can go after your company for back taxes that should have been paid, payroll and income taxes that should have been withheld, and penalties and interest.
Additional penalties may apply if the IRS finds that you intentionally disregarded your tax obligations. And, of course, your state may impose penalties of its own. Finally, “responsible persons” — including certain officers, partners and managers — could be personally liable for uncollected taxes.
Even if workers you treat as independent contractors have paid their taxes, you are not necessarily safe. If the IRS finds they should have been classified as employees, it still may hit you with penalties equal to 20% of your tax liability.
The simplest way to avoid these consequences is to treat workers as employees unless they clearly qualify as independent contractors. The IRS typically examines and weighs certain key factors to determine whether a worker is an employee or independent contractor. These considerations indicate to the IRS the degree of control exercised by the employer and the degree of independence of the worker.
For instance, the IRS looks at behavioral control such as instruction (employees usually receive detailed instructions about when, where and how to work) and training (employees often receive training on how to perform their job duties).
The type of relationship is also important. Does the individual receive benefits? Is he or she working for the business indefinitely? Are his or her services critical to the company’s ongoing operations? Affirmative answers to any or all of these questions would bolster an IRS case that the person in question is an employee, not an independent contractor.
Another important issue is financial control. The IRS will look for unreimbursed business expenses, which are usually incurred by independent contractors, not employees. Independent contractors often make significant investments in facilities and equipment as well. Employees do not.
In addition, employees are usually paid by the hour, week or some other period. But independent contractors generally receive a flat fee or submit an invoice for services. So method of payment is a key consideration. Independent contractors will also often continue marketing themselves while working on a given project and risk suffering a profit loss on every job.
There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. You need to examine and weigh all the factors to determine whether a particular worker is an employee or independent contractor.
Not a bad idea
Engaging independent contractors to fulfill targeted roles in specialized areas of your business is not a bad idea. They may be less costly because you do not have to pay benefits and payroll taxes. But you must carefully evaluate how much risk there is that the IRS could reclassify them as employees.