Properly classified independent contractors can offer cost savings to a business through reduced employer payroll taxes and payroll administrative costs as well as reduced cash flow burden of payroll tax deposits. However, misclassifying employees can subject the business to significant financial and business risk.
Many agencies besides IRS have an interest in the classification of workers. State agencies, such as the California Employment Development Department, and insurers providing workers compensation insurance have an interest in proper classification of employees. Worker classification also impacts eligibility for employee benefit plans. Misclassifying and thus excluding a worker from an employee benefit plan may jeopardize the tax status of the entire benefit plan. The worker classified as an independent contractor and not an employee may have financial incentive themselves to challenge a classification to gain access to benefit plans or workers compensation insurance. This article will review the pitfalls to avoid and best practices to initiate in order to protect your business from the negative consequences of misclassifying employees.
Many of the difficulties in classifying employees arise from the fact that there is no single definition of “employee.” IRS has a 20-factor control test to help employers determine if the nature of the relationship between the employer and the worker qualifies the worker as an employee. Factors such as whether the business requires the worker to be trained, sets the hours of work and sets the work location provide relatively straightforward tests. But other factors, such as the continuity of the relationship and the integration of the worker into the operations of the business are not as easily defined and often depend on the facts and circumstances of the business operations.
Broadly, in the case of an employee, the employer has the right to dictate the job that the worker is doing and how to do it. In an independent contractor relationship, the hiring business determines the desired result of the services but not the method of performing the services.
Certain business practices point more directly to an employer-employee relationship instead of an independent contractor relationship. For example, the way a worker is paid for services can indicate a stronger likelihood that the worker is an employee. Independent contractors are generally paid by the job or on a straight commission basis rather than hourly or weekly.
If in analyzing the worker’s relationship to the business it is determined that the worker can be classified as an independent contractor, there are some steps a business can take to assert this position and minimize costs should IRS examine and reclassify the worker. Put written independent contractor agreements in place for all independent contractors stating the intent to have an independent contractor relationship. Within the contract grant as many freedoms to the independent contractor as possible, including allowing the contractor to set their own working hours, hire their own assistants, work for multiple other businesses and provide their own tools and supplies. The agreement should have a fixed term and no unlimited automatic renewal provisions. The agreement can also ask the independent contractor to prove they have properly reported the income and should definitively state that the contractor is responsible for all state and Federal employment taxes.
Always file all required 1099 forms and tax returns on a basis consistent with the classification of the worker. Consistent treatment by among workers is very important. All workers with similar positions should be classified in the same manner. Year-to-year, a single worker should also be classified consistently.
If a business mistakenly classifies workers in good faith and is found liable for employment taxes, the business can get relief through what is known as the Section 530 “safe havens.” At a minimum, the relief provisions require that the business have a reasonable basis for the treatment and that the business has been consistent in the classification of and reporting on individual workers and groups of workers. As such, it is a good practice to regularly review the census of employees and contractors to ensure that the business continues to maintain consistent practices.
There are many good business reasons to classify a worker as an independent contractor and many cases when that classification is proper. The Aldrich team can perform careful analysis and due diligence to protect your business from potential liability.