Independent Contractor vs. Employee – Beware: Worker Classification Is an IRS Hot Button

A business can realize important advantages by treating a worker as an independent contractor (IC) rather than an employee. But simply labeling someone an IC doesn’t make it so. Properly classifying a worker as an IC or employee depends on several factors related to the level of control you exert over the worker.

Benefits of Independent Contractors

Using ICs allows you to reduce costs in many ways. You do not need to withhold federal income and FICA (Social Security and Medicare) taxes, pay the employer’s share of FICA or pay FUTA (federal unemployment) taxes.

Also, you may avoid certain state obligations, such as income tax withholding, unemployment, workers’ comp and disability insurance. In addition, you don’t have to provide ICs with employee benefits, minimum wages or overtime pay.

What Does the IRS Prefer?

There’s a common misconception that, as long as you provide ICs with Forms 1099 and they satisfy their tax obligations, the IRS and state tax agencies aren’t concerned about your worker classification. But tax authorities prefer employees over ICs for such reasons as:

• • Employers remit income and payroll taxes more quickly (usually monthly), whereas ICs make quarterly estimated tax payments
  • Employers are less likely to default on tax obligations
  • It’s easier to audit, and collect from, a single employer than multiple ICs
  • Generally, tax authorities collect more from employees than from ICs, who are permitted to deduct various business expenses

It’s critical to classify workers properly, given the government’s preference for employees.

Control Factors

The IRS has traditionally evaluated worker status using a 20-factor test that measures the extent of employer control over a worker. The greater the control, the greater the likelihood the worker will be deemed an employee. The IRS has developed a three-factor test in recent years, which groups the 20 factors into the following categories:

1. 1. Behavioral control. Does the employer control what the worker does, and how he or she does it? Factors include the type and degree of instruction given, training provided and systems for evaluating performance.
   2. Financial control. Does the employer control the economics of the job? ICs are more likely to invest in their own equipment, incur unreimbursed business expenses, provide services to multiple customers, receive flat fees and realize profits or losses. Employees are more likely to use the employer’s equipment, get paid based on hours worked, get reimbursed for their expenses, and receive paid vacation and retirement benefits.
   3. Parties’ relationship. ICs are often engaged for discrete projects, while employees are typically hired indefinitely. Workers involved in key business activities are more likely to be classified as employees.

Applicable state or federal laws or regulations may be a factor in determining the level of employer control. Distributors and transportation companies, for example, often treat truck drivers as independent contractors. But electronic logging devices (ELDs) monitor vehicles to ensure compliance with the hours of service law, which limits the amount of time a driver can work in a day. These devices, arguably, allow an employer to control how and when drivers do their work.

Focus on the Risks

Treating a worker as an IC can offer significant benefits, but the consequences of improperly treating an employee as an IC can be severe: You may be liable for all unpaid back taxes (including the worker’s share), plus penalties and interest. In addition, you may owe penalties even if the worker satisfied all of his or her tax obligations.

Plus, ICs reclassified as employees may bring claims to recover benefits, overtime, minimum wages and other rights associated with employee status. Don’t treat anyone as an IC without carefully considering how much behavioral and financial control you have over the worker, along with the nature of your business relationship, to avoid the consequences of misclassification.

If you have questions regarding the benefits or risks of using contractors, we can help. Contact us with this and any other tax questions you may have.