One of the most important decisions to make as you bring in outside help in your business or home is whether to classify those workers as employees or independent contractors with the IRS. It sounds pretty straight-forward. However, even the IRS recognizes that there is no magic formula, and misclassification can result in substantial penalties for you or your business. The key to deciding which is which lies in the degree of control that you, as the employer, maintain over their work.
In general terms, an independent contractor is self-employed. You enter into an agreement or contract with the independent contractor for them to perform a specific role or task. Usually, the contractor will set their own hours and use their own equipment and tools. Many contractors work for multiple clients providing their expertise and services. Oftentimes, they are hired for a defined period of time that is set out in the contract. This period can be renewed or extended upon the agreement of both parties. Contractors will often hire their own workers to assist them in delivery of their product or service. Finally, independent contractors are responsible for their own profit or loss on a job and, unless agreed upon in the contract, they are not usually reimbursed by you for expenses incurred while performing their work.
In contrast, an employee is hired by you or your business under an employment agreement that allows you to dictate what they work on and when they work. Under this type of arrangement, you are required to withhold taxes from their wages, train them, pay the employer portion of their employment taxes and possibly provide benefits. Equipment and tools necessary for the job are generally provided by you or your business. Most employment arrangements are for an indeterminate period of time, and either party can end the arrangement for any valid, non-discriminatory reason. Employees are typically reimbursed for business expenses they incur in the course of their employment.
According to the IRS, the general rule to distinguishing between the two is that an individual is an independent contractor if the payer (your or your business) has the right to control or direct only the result of the work and not what will be done and how it will be done. The IRS has set out three fact categories that provide evidence of the degree of control and independence.
- Behavioral: Does the payer control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? These include things like how the worker is paid – regular salary or flat fee; whether expenses are reimbursed; and who provides the tools/supplies, etc.
- Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue indefinitely and is the work performed a key aspect of the business?
(SquareUp.com – “What’s the Difference Between W-2 Employees and 1099 Contractors”)
These factors must be weighed when making your assessment. It boils down to looking at the entire relationship and considering the extent of your right to direct and control the worker. The IRS further advises that you document the reasoning you use in coming to your determination in case your classification is later questioned. If you don’t have a reasonable basis for your decision, you can be denied any of the penalty relief described below.
If you are still not sure whether to classify the worker as an employee or an independent contractor, then Form SS-8 can be filed with the IRS so that they can review the facts and circumstances and officially determine the worker’s status.
While Form SS-8 can take as much as six months to get a determination, it may be worth the wait since misclassification of an employee as an independent contractor can result in having to repay all of the taxes and benefits that you would have been responsible for otherwise. Some common penalties include:
- Overtime and minimum wage differentials
- Back taxes for Social Security, Medicare and unemployment
- Workers’ compensation benefits
- Any required health insurance, retirement plans, etc.
The IRS does provide some relief from penalties if you have a reasonable basis for your treatment. To be eligible, you must have filed all federal information returns (W-2s for employees and 1099s for independent contractors) consistently with your treatment of the worker. You must also have treated all workers with similar positions in a consistent manner.
If you find yourself convinced you have misclassified your workers and want to be pro-active, the IRS offers the Voluntary Classification Settlement Program as an optional program that provides eligible taxpayers with the opportunity to reclassify workers for future tax periods with partial relief from penalties.
In short, while making the decision on how to classify your workers may not necessarily be straight-forward, it is worth the time it takes to do some research and decide how to classify your workers. ADKF would be happy to sit with you and guide you through this process. Our skilled professional will take our time to analyze, research and help you make the best decision for your business. We look forward to hearing from you.