Get it Right the First Time: Employee vs. Independent Contractor Status
How does a business determine if its workers are employees or independent contractors? This distinction is not as simple as most may think.
The old adage of “My workers are subcontractors because they pay their own taxes,” is not one of the 20 questions that the IRS or state labor agencies use to determine worker classification – and that defense would not ever carry any weight in an employment audit. In an era where worker misclassification and due diligence requirements are at an all-time high, accounting professionals must understand all the complexities. Improper classification not only carries a huge burden on the business, but can also have a significant impact on the worker.
If the IRS determines employees were erroneously classified as independent contractors, the IRS may notify the workers that they are not entitled to deduct their business expenses from gross income on Schedule C and/or that they were not entitled to contribute to a retirement plan because they are not self-employed. When the IRS prohibits business expense and deduction claims for contributions to self-employed retirement plans, it can be very costly to the worker.
In addition, when a business fails to properly classify its worker as employees, these individuals are unable to participate in benefit programs, such as health insurance provided by the employer. This issue, which usually arises after the fact, can catch a worker by surprise and put them in a predicament that oftentimes they are not prepared to resolve.
Yet, the consequences and impact on the business are far greater than those for the misclassified worker. In most cases, businesses categorize workers incorrectly due to lack of knowledge and understanding of the guidelines. However, in some cases, the misclassification is clearly willful and negligent. There are only so many employments audits the IRS and state labor agencies can conduct, but should a business that is negligent go through an audit, the consequences can be quite severe.
For example, a willfully careless business that has its workers misclassified will not only be responsible for the tax liability, the penalty for improper classification and the penalty for failure to file returns, but will also be responsible for the 100% penalty for willful failure to collect tax. By the time the audit case is closed, a business may owe three times as much just for improperly classifying their workers.
Most times, employment classification issues occur at the state level. In today’s tough economic times, workers will apply for unemployment compensation, which triggers the state unemployment office to conduct an investigation when it discovers that the business doesn’t have the worker classified as an employee. Other times, employment classification issues are triggered by workers’ compensation claims, or complaints to the state unemployment board about a work-related situation. It’s usually the least expected situation that can get a business under fire for worker misclassification.
While it’s quite clear what the consequences are to the business and the worker for improper classification, it isn’t always clear how a business determines if its workers are employees or independent contractors. The key issue that the IRS asks about is whether the business had “control” over the worker. Control is the clear-cut word, but how control is determined is not so clear cut.
In order to determine if a business had control, the IRS will generally consider 20 questions in making the final determination of worker classification. Keep in mind that not all these inquiries apply in every worker classification audit. Often, the IRS will use only those questions that apply, depending on the industry the business is operating in. Of these 20 questions, here are nine that most businesses can use to make a fairly safe and correct classification of their workers:
When conducting worker classification audits, these are some
of the questions that are considered by the IRS and state
labor agencies. Worker classification audits have a
case-by-case basis, so the degree of importance given to the
answers of each of the 20 questions will vary depending on
the business and its situation.
Remember, too, that a business will be in an industry where IRS or court case rulings on worker’s status exist and set precedence. Therefore, it’s not necessarily where the business thinks their worker’s should be, but rather what prior case rulings dictate.
Understanding the guidelines and properly classifying workers can prevent an audit, as well as save the business significant money in penalties and interest. There is nothing better than getting it right the first time!