Business owners often may not understand when to classify an individual as an employee versus an independent contractor. Proper classification of a worker as an independent contractor may save a company money and benefits, such as group health and workers’ compensation insurance, as well as social security and unemployment insurance taxes. In most cases, the only tax form employers have to complete is a Form 1099-MISC at the end of the tax year for workers classified as independent contractors. It is important to ensure that workers are classified correctly. Misclassification can result in significant liability.
Classifying workers as employees, on the other hand, requires that the company: withhold federal, state, and local income taxes; pay half of the tax mandated under the Federal Insurance Contributions Act (for social security and Medicare); pay the full tax required under the Federal Unemployment Tax Act and any state unemployment insurance tax laws; pay for workers’ compensation; file a number of returns during the course of the year with the various tax authorities; and provide W-2s by January 31. The employee may also have rights to any employee benefits offered, such as health insurance, vacations, holidays, or retirement plans.
The IRS has given guidelines to its agents to help determine worker status. In the past, a list of 20 factors compiled by the IRS had been used in court decisions to determine worker status.
The list, sometimes called the 20-factor test, is still used as an analytical tool, although some of the factors are no longer as relevant as they once were. More recently, agents are directed to focus on the overall situation rather than to emphasize one or two of the 20 factors.The determination of whether a worker is an employee or an independent contractor is based on common-law rules, which look at the relationship of the worker and the business, taking into consideration all evidence of control and independence.
Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of:
• Instructions the business gives the worker. An employee is generally subject to the business’s instructions about when, where, and how to work. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved.
• Training the business gives the worker. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.
Facts that show whether the business has a right to control the business aspects of the worker’s job include, but are not limited to:
• The extent to which the worker has unreimbursed business expenses.Independent contractors are more likely to have unreimbursed expenses than employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses inconnection with the services they perform where they work.
• The extent of the worker’s investment. An independent contractor often has a significant investment in the facilities or equipment he or she uses in performing services for someone else. However, a significant investment is not required.
• The extent to which the worker can realize a profit or incur a loss. An independent contractor can make a profit or loss.
Facts that show the type of relationship between parties include, but are not limited to:
• Written contracts describing the relationship the parties intended to create.
• Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay.
Risks When You Misclassify Employees
Intentionally misclassifying employees as independent contractors may result in penalties plus interest. The exposure for unintentional misclassification of an employee is serious, but not as serious as the risk for an intentional misclassification. Here is what’s at stake:
If the employer filed a Form 1099, unintentionally misclassifying an employee, the employer’s liability for federal income tax withholding is limited to 1.5% of the employee’s wages. The employer’s liability for FICA taxes would be 20% of the employee’s share, plus the entire amount owed by the employer. And, the employer would have no rights to recover from the employee what is due to the IRS. If an employer has not filed any information returns that were required, such as the Form 1099, the percentage amounts are doubled. The employer must pay 3% for federal income tax withholding and 40% of the employee’s portion of FICA in addition to the employer’s share of FICA.
Additionally, the employer would still be liable for unemployment taxes. Interest and penalties could be assessed by the IRS, but only on the amount of the employer’s liability. The employer’s liability includes the percentage of tax that should have been withheld. For example, interest for failure to collect FICA would be based on the employer’s share of FICA plus the 20% of the tax that should have been withheld from the employee.
Intentionally misclassifying an employee could result in the following employer liabilities: the full amount of income tax that should have been withheld (with an adjustment if the employee has paid or does pay part of the tax); the full amount of both the employer and employee shares for FICA (but might receive an offset if the employee paid FICA self-employment taxes); and interest and penalties, computed on far larger amounts than in the case of an unintentional misclassification. In addition to the back taxes, criminal and civil penalties may be issued.