Beware: Worker classification is an IRS hot button
Treating a worker as an independent contractor (IC) rather than an employee can provide a business with important advantages. Whether a worker is classified as an IC or an employee depends on several factors targeting the level of control you exert over the worker.
Per the IRS, the general rule is, “an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done.”
Using ICs allows you to reduce costs in many ways. For example, there is no need to withhold federal income and FICA (Social Security and Medicare) taxes, pay the employer’s share of FICA or pay FUTA (federal unemployment) taxes.
You may also avoid certain state obligations, such as income tax withholding, unemployment, workers’ compensation and disability insurance. Additionally, you do not have to provide ICs with employee benefits, minimum wages or overtime pay.
There is a common misconception that the IRS and state tax agencies are not concerned about worker classification as long as you provide ICs with Forms 1099 and they satisfy their tax obligations. However, tax authorities prefer employees over ICs for several reasons, including the following:
- Employers remit income and payroll taxes more quickly (usually monthly), whereas ICs make quarterly estimated tax payments.
- Employers are less likely to default on tax obligations.
- It is easier to audit and collect from a single employer rather than multiple ICs.
- Generally, tax authorities collect more from employees than from ICs, who are permitted to deduct various business expenses.
Given the government’s preference for employees, it is critical to classify workers properly.
Traditionally, the IRS has evaluated worker status using a 20-factor test that measures the extent of employer control over a worker. The greater the control, the greater the likelihood the worker will be deemed an employee. In recent years, the IRS has developed a three-factor test, which groups the 20 factors into the following categories:
- Behavioral Control
Does the employer control what the worker does and how he or she does it? Factors include the type and degree of instruction given, training provided and systems for evaluating performance.
- Financial Control
Does the employer control the economics of the job? ICs are more likely to invest in their own equipment, incur unreimbursed business expenses, provide services to multiple customers, receive flat fees and realize profits or losses. Employees are more likely to use the employer’s equipment, get paid based on hours worked, get reimbursed for their expenses, and receive paid vacation and retirement benefits.
- Parties’ Relationship
ICs are often engaged for discrete projects, while employees are typically hired indefinitely. Workers involved in key business activities are more likely to be classified as employees.
In some cases, applicable state or federal laws or regulations may be a factor in determining the level of employer control. For example, distributors and transportation companies often treat truck drivers as independent contractors. But electronic logging devices (ELDs) monitor vehicles to ensure compliance with the hours of service law which limits the amount of time a driver can work in a day. Arguably, these devices allow an employer to control how and when drivers do their work.
Consider the risks
While treating a worker as an IC can offer significant benefits, the consequences of improperly treating an employee as an IC can be severe: You may be liable for all unpaid back taxes (including the worker’s share), plus penalties and interest. And you may owe penalties even if the worker satisfied all of his or her tax obligations.
Plus, ICs reclassified as employees may bring claims to recover benefits, overtime, minimum wages and other rights associated with employee status. To avoid the consequences of misclassification, do not treat anyone as an IC without carefully considering how much behavioral and financial control you have over the worker, along with the nature of your business relationship.
For more information, contact Seamus Donoghue at [email protected] or 312.670.7444.