Many employers mistakenly believe that the misclassification of employees as independent contractors does not really matter, so long as contractors satisfy all of their tax obligations. However, this could not be further from the truth. This article explains the stakes involved when employers classify workers as employees or independent contractors.
Independent Contractors vs. Employees
Many employers mistakenly believe that the misclassification of employees as independent contractors does not really matter, so long as contractors satisfy all of their tax obligations. However, this could not be further from the truth. Improper classification of workers comes at a high cost and both federal and state authorities have been cracking down on the practice in recent years. We have found that during IRS exams this is an area typically focused on by agents.
Advantages of Independent Contractor Status
It is no surprise why employers prefer to treat workers as independent contractors. If workers are legitimately treated as contractors, the employer avoids a variety of financial obligations associated with employees, including withholding federal income taxes, paying the employer’s share of FICA taxes, withholding the employees’ share and paying federal unemployment taxes (FUTA). The employer may also avoid obligations under state law, such as withholding state income taxes, paying state unemployment taxes, paying or withholding state disability insurance contributions and furnishing workers’ compensation insurance. However, some states may require employers to provide workers’ compensation to contractors or pay unemployment tax on amounts paid to contractors in certain situations. In addition, contractors are not entitled to employee benefits, minimum wage, overtime, retirement pay benefits and other rights enjoyed by employees.
Why it Matters
Although there are many advantages to the company, the tax authorities have a very different perspective on this issue. A common assumption is that if the independent contractor pays all their taxes, then the government should not care. However, the government is actually concerned for several reasons:
- Employers are less likely to default on their tax obligations;
- It is much easier to collect taxes from a single employer than from many independent contractors;
- Even if all taxes are collected, the government also wants to maximize unemployment contributions; and
- The U.S. Department of Labor, state labor departments and other security agencies have an interest in expanding the class of workers entitled to employee benefits, wage and hour protections, and workers’ compensation coverage.
The consequences of misclassification can be harsh. If the IRS determines that contractors should have been classified as employees, it may require the employer to pay back taxes and the employees’ share of unpaid payroll and income taxes, plus penalties and interest. Additionally, if the employer lacks the resources to pay these liabilities, the IRS can collect from “responsible persons,” including certain executives, partners or managers. Keep in mind that federal and state tax authorities can also impose penalties on employers who misclassify workers regardless of whether or not their contractors satisfy their tax obligations.
How to Protect Yourself
This does not mean a business should never use independent contractors. If your business does use independent contractors, conduct an assessment to determine whether they are considered employees under federal and state law. In making this determination, the IRS examines a variety of factors that reflect the level of behavioral and financial control you have over a worker, as well as the nature of your relationship. For example, workers are more likely to be considered contractors if they control how and when the work is done, cover their own expenses, invest in their own facilities and tools, make their services available to the relevant market and can realize profits or incur losses. The IRS also considers the parties’ written agreements, benefits provided to the worker and the permanency of the relationship.
Given the steep price of misclassification, be proactive when it comes to the employee versus contractor status. A good practice is to review your independent contractors once a year to make sure their status has not changed. Verify you have a set checklist on file for each contractor indicating why they meet the criteria established by the government. The best practice is to do this in January or February after preparing their required 1099’s. Assigning someone this responsibility and establishing a process to monitor this matter will help prevent issues in the future. If you are concerned about potential liability, discuss options with your tax advisor and consider participating in voluntary classification settlement programs. These programs allow you to resolve these issues with the IRS or other government agencies at the lowest possible cost.