Independent Contractor vs. Employee Status
Hiring an independent contractor is often the simplest way for a business to get help in the door. However, the IRS, state labor and employment boards, unemployment insurance and worker’s compensation authorities all investigate whether or not employers are properly classifying workers. If any of these authorities determine that a worker that is being treated as an independent contractor should actually be an employee the remedies to correct the misclassification can be costly.
There are many benefits of classifying a worker as an independent contractor such as not providing the contractor with employee benefits, avoiding employer payroll tax liability, the ability to budget a specific amount for a project without paying overtime or holiday pay, savings in clerical costs and recordkeeping, less liability, and savings on workers compensation and unemployment insurance. While a hired independent contractor and employer may be in agreement in regards to their status, the IRS or other authority could disagree if they deem the relationship falls under the definition of employer-employee.
If the IRS or other authority determines that a worker classified as an independent contractor is actually an employee it can prove costly—the employer will be liable for past employer payroll taxes as well as penalties and interest and the burden of filing or amending all necessary payroll tax returns. If the issue is serious enough court time and costs or even criminal sanctions could result. Also, any retirement plans or other benefit plans that require certain compliance could be invalidated.
In order to avoid reclassification, employers should become familiar with the three main factors that are evaluated to determine the relationship between the business and worker: behavioral control, financial control and type of relationship. Behavioral control will be examined to determine if the employer gives extensive instructions and training that would result in strict adherence to company policies and procedures. If an employer exerts significant behavioral control or requires strict compliance with the processes and procedures of a company, this may indicate employee status. Financial control is also a relevant factor. Reimbursed expenses, purchase and use of tools by the employer for use by a worker on a project and lack of an investment by the worker signifies financial control by the employer, which could indicate employee status. Finally, the relationship of the parties may also be evaluated in the determination, in which case whether or not the contractor is receiving benefits, insurance coverage or any other coverage that may favor an employer-employee arrangement. While these are the overall factors that are evaluated it is not an exhaustive list of what may be considered in determining status.
An employer can consult publications and presentations prepared by the IRS and the EDD that cover the factors that are evaluated to determine classification. The IRS has an online lesson (Lesson 6) under its Virtual Small Business Workshop that discusses classification. Click here to access the workshop. Access to additional IRS guidance can also be found on their website by clicking here. EDD publication DE 38 – Employment Determination Guide provides information and examples that can assist in determining classification. If there is a dispute between the employer and worker over the proper classification Form SS-8 can be filed with the IRS, allowing them to make the determination for you. However this process can take up to six months and is known to favor employee classification.
When making classification decisions industry practices and norms should not necessarily be followed. Each situation should be individually evaluated and factors that indicate a relationship is employer-employee should not be downplayed. If independent contractor status can be justified, assure that the arrangement is supported with proper documentation. An agreement should be drawn up and signed by both the contractor and employer showing the nature and terms of the relationship. All transactions that need to be made, such as insurance coverage, bonding, etc, should be made just as they would be through any other vendor. Have a vendor file prepared and maintained for the contractor and keep any records of bids, advertisements, business cards, 1099-MISCs filed, etc. If the IRS or EDD inquires, having a file with all the support that went into hiring and classifying the independent contractor assertion will help make a solid case for the company’s position.
Worker reclassifications occur across all industries and sizes of companies. Industries that employ outside salespeople or seasonal, short time, casual, or construction workers tend to have the highest misclassification rate. It is in a business’ best interest to classify workers correctly from the outset and avoid the time and money that comes along with correcting a misclassification. If you are unsure of the status of your workers your LMGW advisor can provide you with checklists and due diligence processes in order to assure that workers are properly classified.
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