Beware of the Employee/Independent Contractor Classification Conundrum

Misclassification of workers as independent contractors rather than employees is a major issue for companies of all sizes and in all industries, one that carries significant civil and criminal penalties if applied incorrectly. Further, because this can cause federal and state governments to lose large quantities of revenue, Congress and the IRS are increasing their scrutiny on this issue. Employers must understand the difference between an employee and an independent contractor.

According to the IRS, generally, 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 and how it will be performed. Consider the degree of control and independence in the employer/worker relationship for each situation.

Common Law Test Categories

Behavioral – A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. More specifically (1) types and degree of instruction given, such as when and where to work, may indicate if this is an employee; (2) evaluation systems, if they measure the details of how the work is done, may indicate if this is an employee; and (3) training a worker on how to do the job may also indicate if this is an employee.

Financial – Are the business aspects of the worker’s job controlled by the payer? Consider (1) the amount of investment in the equipment the worker uses; (2) independent contractors are more likely to incur unreimbursed expenses compared to employees; (3) potential for profit or loss often indicates an independent contractor; (4) independent contractors are generally free to look for other business opportunities; and (4)  independent contractors are generally paid a flat fee, whereas employees are generally guaranteed a regular wage amount based on period of time, even if supplemented with a commission.

Relationship – The type of relationship depends upon how the worker and business perceive their interaction with each other. This includes (1) a written contract that describes the relationship between the parties; (2) employee benefits offered such as insurance, pension plan, vacation and sick pay; (3) expectation that the relationship will continue indefinitely is seen as intent to create an employer-employee relationship; and (4) the extent to which services performed by the worker are seen as a key aspect of the regular business of the company.

If business owners classify the worker as an employee, then typically the person will receive a Form W-2.  The business owner is then responsible for withholding and paying income taxes, Social Security and Medicare taxes, and Department of Labor taxes. An independent contractor will be issued a Form 1099 Miscellaneous, and the business owner is generally not responsible for withholding any taxes.  As such, misclassification is sometimes deliberately performed in order to reduce costs but, again, significant penalties can apply. 

Avoid unintentional misclassification through a better understanding of the differences between an employee and an independent contractor. It’s worth noting that the rules are complex and can vary between the IRS and the states. Again, due to the impact on federal and state tax revenue, worker classification will become an increasingly scrutinized area. This is where a tax advisor with the particular expertise can help mitigate risk and add value to the business.