Classifying a Worker as Employee or Contractor
By Matt Dickstein
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Most businesses want to classify their workers as contractors not employees. Contractors are cheaper and easier than employees. You don’t withhold taxes for contractors, nor do you pay benefits, workers compensation or unemployment insurance, nor must you comply with the wage & hour laws (including overtime) for contractors.
Who is an employee and who is a contractor?
To determine who is an employee, the IRS considers 3 factors:
(1) whether the employer has behavioral control over the worker, that is, whether the employer controls how the worker does the job;
(2) whether the employer has financial control over the worker, that is, whether the worker is invested in his own business, has other clients, and is not dependent on the employer; and
(3) the relationship between the parties, which takes into account that contractors usually work on projects. Contractors usually do not work open-ended jobs, and do not provide the core services that the business offers to its customers, e.g. in a car repair shop, workers who fix cars usually are employees not contractors.
In most companies, using the above 3 factors, hired workers look more like employees than contractors. The exceptions are obvious, for example, service providers like lawyers, accountants, web designers and the like, who are independent and provide their services to many different clients. The exceptions aren’t fullproof, however: if an accounting firm hires a CPA to do tax returns for its clients, the accountant probably is an employee of the firm.
If your company believes it can safely classify a worker as a contractor, then be sure to comply with the safe harbor at IRS Section 530. Specifically, don’t convert an existing employee to contractor status without a significant change in job duties; where you have workers doing the same job, don’t classify some as employees and others as contractors; and be sure to file all tax returns on a basis consistent with the classification as contractor.
I advise clients to classify hired workers as employees, with the sole exception when a worker is obviously a contractor. The risks of misclassification outweigh the benefits. If you get caught, you must pay all of the back payroll taxes, workers compensation, overtime and more, plus penalties and interest.
The penalties hurt the most. The IRS assesses a penalty based on its opinion of you. If the IRS believes your story, the penalty can be as “low” as 20% of the FICA that should have been withheld and 1.5% of wages. If the IRS thinks you deliberately misclassified, it can hold you responsible for all employment taxes that should have been paid, including income tax and the employee’s share of FICA and FUTA. Worse, the IRS can seek recourse from the practice owners and officers individually for the entire liability – there is no corporate shield.
In brief, the bill for misclassification gets very big very fast, and it’s not worth the risk.
But will I get caught?
I don’t know if the IRS will find you out. I only know that the IRS makes good money from misclassifications, hence it has incentive plus expensive computer systems to catch you. Worse, I know that your own employees and contractors will be the first informants in line when an employment dispute arises.
Lastly, if you want to reclassify a contractor and call her an employee, try to do it as of January 1. With a January 1 effective date, the worker should not receive a 1099 and a W-2 in the same year for the same job, which could trigger an audit.
I hope this article helps you. Please get competent legal counsel when deciding if a worker is an employee or contractor.