As the economy suffered, many employers attempted to save money and gain flexibility by utilizing independent contractors as opposed to employees. Using independent contractors can save employment taxes and benefits costs while also allowing for more flexible work arrangements if work levels are sporadic or uncertain. However, misclassifying an employee as an independent contractor can result in severe tax costs for the unwary.
The Internal Revenue Service believes that payroll tax examinations are one of the most cost-effective ways to generate additional tax dollars from non-compliance. Beginning in 2010, the IRS began examining 6,000 randomly selected employers as part of its National Research Program. Additionally, the IRS and a majority of states share the results of employment tax examinations with each other. Because of this environment, correctly classifying workers as employees or independent contractors should be at the front of your mind. The question of whether a worker is an independent contractor or employee is a complex one, and one which could potentially be costly.
At the risk of over-simplifying, if the business controls not only what, but how something is to be done, then the relationship is likely that of an employee. However, if the business only controls the results of the work, but not the means or methods, the relationship is likely that of an independent contractor. However, the determination is highly dependent on all of the facts and circumstances of the relationship.
The IRS uses three key characteristics to determine whether a worker is an employee or independent contractor:
- Behavioral control– whether the business has the right to direct or control the “how”
- Instructions the business gives to the worker, including:
- When and where to do the work
- What tools or equipment to use
- What workers to hire or assist with the work
- Where to purchase supplies and services
- What work is to be performed by a specific individual
- What order or sequence to follow
- Training or other means – Generally, an employee is trained by the business to perform services in a particular manner; however, an independent contractor uses his or her own methods
- Financial control– whether the business has the right to direct or control the financial and business aspects of the worker’s job
- Who is responsible for expenses incurred?
- Does the worker have a personal investment in tools and facilities?
- Is there a potential profit or loss to the worker?
- Is the worker free to offer his or her services to other businesses?
- How is the worker paid? Hourly, flat fee, time and materials?
- Type of relationship– how the worker(s) and business owner(s) perceive their relationship
- Are there written contracts describing the relationship?
- Does the business provide employee-like benefits such as insurance, a retirement plan, vacation or sick pay?
- What is the expectation of the length of the relationship – permanent or project-based?
- How easily can the relationship be terminated?
- How integral are the worker’s services to the business?
Unfortunately, none of these factors is determinative and not all factors are required for either type of relationship. The best you can do is to build a case for your position and treat workers in similar situations in the same manner.
Fortunately, if you believe that your business might be misclassifying workers, there are steps you can take to minimize any tax assessment, as the result of an examination. A safe-haven rule, known as Section 530 relief, provides a taxpayer protection from past employment tax obligations if those workers are found to be “common-law” employees, assuming the following requirements:
- You never treated the workers in question as employees.
- You filed Form 1099 for those workers, stating independent contractor status.
- You always treated workers in the same position as independent contractors.
- You are using a “reasonable basis” for not treating those workers as employees.
“Reasonable basis” automatically exists in the following situations:
- The IRS previously examined your business without reclassifying workers in a substantially similar role.
- A court decision or IRS ruling specifically states that individuals in a similar position were correctly classified as independent contractors.
- Workers are historically treated this way in your industry.
If you have questions or if you believe you may have an issue with employee versus independent contractor, please contact us to make sure you are doing everything required to minimize any future impacts on your business.