A recent hot topic has been the independent contractor versus employee discussion, not only because the IRS is looking to prop up declining tax revenues in this bad economy, but also because the IRS recently kicked off their National Research Program (NRP) study (the first one in 25 years) that is focused on Employment Tax Compliance. This project will randomly examine or audit 2,000 businesses each year for the next 3 years with a focus on worker classification, fringe benefits, executive compensation, expense reimbursement, and other payroll related issues. This “study” will help the IRS find the percentage of businesses with some of the former employment tax topics discussed. By understanding compliance percentages in each payroll area of interest, the IRS can improve their audit selection procedures and standards.
About 25 years ago, the IRS did a similar study that found that the misclassification of workers as independent contractors led to the loss tax revenues of $1.6 billion (more than 3.2 billion today). However, the IRS estimates this number is much higher today because independent contractors represent a growing percentage of the workforce, abetted by advancements in communication technologies.
If the IRS ascertains that you have incorrectly classified a worker as an independent contractor, you could be responsible for payroll taxes including the FICA (Medicare and Social Security) and FUTA (unemployment taxes), plus interest and penalties. If the IRS can prove that you intentionally misclassified a worker as a contractor to evade taxes, you could be hit with a Trust Fund Recovery Penalty, which is 100% of the taxes owed plus interest.
So What Are Some General Guidelines to Follow In Order To Correctly Classify A Worker?
The relationship between the company and the worker needs to be reviewed from a control and independence perspective. The IRS provides guidance in determining whether a worker is an independent contractor (IC) or employee under common law rules. In 1987, the IRS put forth 20 factors to review to help with proper classification of a worker as an employee or an IC. These factors are to be used with a set of broadly defined common control factor categories: Behavioral Control, Financial Control, and the Type of Relationship.
Behavioral Control pertains to facts that illustrate whether the business has the right to control or direct how the worker completes the tasks at hand. It covers facts such as the type of instructions provided (when, where, and how tasks are to be completed), the level of the instruction, the training, and so forth. Instruction and training are very important factors to the IRS’s determination.
Financial Control pertains to facts that show whether the business has the right to dictate or direct the economic elements of the worker’s duties. This includes the degree of expenses not reimbursed, the level of the worker’s investment, the profit or loss potential of the worker, the method of compensation, and the degree the worker makes services widely available to other businesses. To the IRS, the financial stake/profit or loss aspect is a critical component.
Type of Relationship describes the type of relationship existent between the worker and the business. Written contracts, employee-type benefits, the level of business integration with regards to the services, and the duration of the relationship.
All of these criteria are very important and must be evaluated when trying to accurately account for a worker.
Some Guidelines to Prevent the Misclassification of a Employee as an Independent Contractor
- Make sure the tools needed for the job are the Independent Contractor’s
- Verify the Independent Contractor works for other businesses or intends too (if newly created)
- Ensure the Independent Contractor can hire or subcontract out parts of the tasks needed to be completed
- Make certain your Independent Contractor sends you invoices that you file and keep for your records
- Make sure you tell your Independent Contractor what needs to be completed and not how and when (like 9-5pm)
- Work with Independent Contractors who own or are part of a business entity
- Setup an Independent Contractor contractor agreement or contract that spells out the relationship accurately
- Do not provide training as this can easily be looked at by the IRS as a sign the worker is an employee