Employee versus Independent Contractor

For many years business owners and decision makers have walked a fine line in classifying the people performing services for their companies.  Is the person an employee or are they an Independent Contractor?  More so than ever, it is imperative to “pay” very close attention to the IRS rules and regulations when faced with this decision.  The IRS has launched programs that focus on these misclassifications which the Government estimates costs them approximately $2.72 billion in unpaid federal taxes, state workers’ compensation and unemployment.

In addition, the IRS is now in a joint program in conjunction with the Department of Labor (DOL) where they share data related to worker misclassifications.  The IRS and the DOL also have agreements in place with more than 30 states to also share this information.

In determining whether the worker is an employee or an independent contractor, the IRS looks at the evidence of the degree of control and independence.

  • Behavioral – Does the company control or have the right to control what the worker does and how the worker does his or her job?
  • Financial – Are the business aspects of the worker’s job controlled by the payer? (These include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
  • Type of Relationship – Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the worker performing a key aspect of the business?

In an effort to promote compliance, the IRS launched a new the program called “The Worker Reclassification Settlement Program.”  This is a voluntary program that allows a participating employer that has (or may suspect they have) misclassified workers as Independent Contractors to avoid problems with the IRS by agreeing to treat the works as employees in the future.

Here’s how it works. The employer pays 10% of the employment tax liability that should have been paid the year prior, had the workers been properly classified as employees. This is paid with NO penalty or interest.  The employer will not be audited on the reclassified workers payroll taxes for other past years.  The one downside is that during the first 3 years of participating in the program, employers are subject to a 6 year statute of limitations (instead of 3 years) for payroll tax liability issues.

Take the scrutiny the IRS applies to this area very seriously.  Properly classifying your workers from day one will save you, your worker and your company time, frustration and money in the long run.  If you find yourself debating between the classification as a way to cut your cash flow, consider that the savings is actually immaterial (approximately 10 to 15% of gross) when compared to the risk.  Additionally, take a look at ways to cover these costs in your business model, especially if the worker is directly related to revenue generation.  You could raise your rates or your product price in proportion to these additional costs…food for thought.



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