When a business hires a worker, it must classify the worker as either an employee or an independent contractor. This decision is important due to the legal and financial implications. However, the rules for classifying a worker are complex and subjective. If a worker is misclassified, it may be costly for the business.
WHY DOES IT MATTER?
There are substantial savings in classifying workers as independent contractors instead of employees. Employees generally expect certain benefits from their employers, such as health insurance, a 401(k) plan, a section 125 or cafeteria plan, and paid time off, among others. Businesses generally don’t pay these expenses for independent contractors. Employers are responsible for compliance with a plethora of employment laws, rules, and regulations. Many of these compliance issues simply don’t apply to the relationship between a business and an independent contractor. If a business improperly classifies a worker as an independent contractor rather than an employee, the business risks disqualification of company retirement plans if it improperly excluded the worker.
The Patient Protection and Affordable Care Act requires employers to provide affordable health insurance that is based on the number of employees. The mandate applies to businesses with 50 or more employees, and there is a penalty for failure to comply. If a business with over 50 workers classifies enough of those workers as independent contractors, then neither the mandate nor the penalty would apply should the business choose not to provide insurance.
Businesses are required to pay social security, Medicare, and unemployment tax on their employee’s wages. There is no such requirement to pay these taxes for independent contractors. A business can save significantly on its taxes based on this worker distinction. Business may face retroactive assessment of employment taxes for taxes due (and not withheld) from worker compensation.
For this reason, the IRS is highly interested in the proper classification of workers. Misclassifying workers as independent contractors, when they should be considered employees, costs the IRS billions of dollars in tax revenue each year. An IRS audit in this area can be quite costly.
HOW IS WORKER STATUS DETERMINED?
The general rule is that anyone who performs services is an employee if the employer has the right to control what will be done and how it will be done. Conversely, an individual is an independent contractor if the person for whom the services are performed has the right to control or direct only the result of the work, and not the means and methods of accomplishing the result.
As a practical matter, it is sometimes a difficult and complex task to determine a worker’s status. Businesses, the IRS, and the Tax Court must consider all the facts and circumstances relating to the actual working relationship. There is no “bright-line” rule to determine whether a worker is an employee or an independent contractor.
The IRS uses a collection of 20 factors to consider the facts and circumstances of each case. These factors are split among three categories: behavioral control, financial control, and the type of relationship between the parties.
To determine behavioral control, the IRS will consider the instructions that a business gives to a worker. If the business is telling the worker what equipment to use, where to purchase the equipment, and the order or sequence to follow, then this suggests the worker is an employee. If the worker must work specific hours or keep a certain work schedule, and if the business can hire or fire the worker, it implies that an employer/employee relationship exists. If a business trains a worker and provides ongoing instruction, this also suggests an employee relationship. Independent contractors generally determine the equipment needs themselves, and use their own methods to complete a job.
To determine financial control, the IRS will consider the extent to which the worker has unreimbursed business expenses. Such expenses are more commonly found among independent contractors. Fixed ongoing costs that are incurred even when no work is being performed are important. An independent contractor will often have a significant investment in the equipment used. Independent contractors are generally free to seek out business opportunities, advertise, and maintain a visible business location. Employees are generally paid a regular wage amount and do not realize a profit or loss.
TYPE OF RELATIONSHIP
When considering the type of relationship, the IRS looks to written contracts describing the relationship. Businesses should take care not to rely too heavily on this one factor since the nature of the relationship is what matters most, and not the name. Providing employee-type benefits, such as a pension plan, is indicative of an employee relationship. The IRS also considers the permanency of the relationship and the extent to which services performed by the worker are a key aspect of the regular business of the company.
MINIMIZING THE RISK OF IMPROPER CLASSIFICATION
Businesses may minimize the risk of retroactive imposition of employment taxes due to improper worker classification if the business had a reasonable basis for treating the workers as independent contractors, if the treatment was consistent from year-to-year, and if forms 1099-MISC were issued for each worker.
Due to the risks associated with improper worker classification, businesses should carefully consider these rules when bringing in new staff.
This information presented is only of a general nature, may omit many details and special rules, is current only as of its published date, and accordingly cannot be regarded as legal or tax advice. Any tax advice contained in this communication is not intended or written to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties. Please contact our office (603-627-3838) for more information on this subject and how it pertains to your specific tax or financial situation. Howe, Riley & Howe, PLLC would be happy to answer your tax and financial questions regarding these issues or other matters that may be of interest to you or your business.