The Employee/Contractor Classification Conundrum

Worker classification continues to be a top-of-mind issue for the federal government, specifically the Department of Labor and the Internal Revenue Service. Here’s what they’re concerned about (which means this is what you, too, should be concerned): withholding taxes, employee health benefits, retirement plan participation and more. The IRS relies on three tests to determine worker classification.

Worker Classification Tests

Behavioral – Does the company control or have the right to control the way a worker performs his/her work? Companies normally do this with employees. However, a company hiring an independent contractor normally defines a goal or end product, with the contractor bearing the burden of achieving the goal or end product.  

Financial – Examine how the company controls the economics of the worker’s labor. Companies provide employees the tools to do their jobs. Independent contractors work on an agreed-upon, fixed fee or cost/material basis. Contractors need to determine which tools to use and assume the costs and risks to complete projects.

Relationship Type – A company typically develops a long-term relationship with its employees and provides such benefits as health insurance, retirement plan contributions and paid time off. Independent contractor relationships center on a project that has a definitive beginning and ending, rather than one that is indefinite.

Paperwork

If a worker is treated as an independent contractor, it is incumbent upon the company to issue a Form 1099-MISC to the contractor each January for the work done during the previous year. The form must be issued for all unincorporated service providers who have received payments from the company that exceed $600.

Section 530 Defense

A word about the Section 530 defense: Enacted approximately 40 years ago, it was designed to counter “over auditing” by the IRS in this area.

This can be good tactic when faced with a worker classification audit, but the company must issue the Form 1099-MISC, as well as consistently treat the contractors and individuals doing similar type work as contractors. Further, the company must have reasonable basis for its classification, which includes (1) a court ruling or letter ruling to the taxpayer; (2) a prior audit where no assessment was made for workers holding positions similar to those at issue, and the worker classification was specifically reviewed during the audit; (3) a long-standing recognized practice within the industry in which the worker is engaged; or (4) the company had relied on some other reasonable basis, such as a business attorney or accountant who was familiar with the facts concerning the worker classification.

While there can often be a fine line between what makes someone an employee or a contractor, it is imperative to perform the necessary due diligence to make an accurate determination.