If your business hires people to help with the work (whether office tasks or production of goods or services), then you need to properly classify the workers as employees or independent contractors.

Here is one important reason why classification matters: Generally, you must withhold income taxes and withhold and pay Social Security and Medicare taxes and unemployment tax on wages paid to employees. You generally do not have to withhold or pay taxes on payments to independent contractors for the work they do for you.

It may be tempting for a business to misclassify workers as independent contractors and not as employees. Independent contractors are not subject to the minimum wage and overtime provisions of the Fair Labor Standards Act, nor are they generally eligible for unemployment or worker’s compensation benefits or employer-provided fringe benefits.

The issue of worker classification has captured the attention of the IRS. The head of employment tax policy for the IRS recently told the American Bar Association about plans to increase enforcement of worker classification regulations. This means that businesses should anticipate increasing review over their classification of workers as independent contractors instead of as employees.

Employers who misclassify employees face an array of possible penalties. The IRS may seek to recover unpaid employment taxes from employers who misclassify an employee as an independent contractor. Employers also face potential overtime compensation, FICA, worker’s compensation, ERISA issues and other tax liabilities on the federal and state levels.

Proper classification is based on various criteria, but the most basic criterion is the “right of control.” Generally speaking, an employer-employee relationship exists when the person for whom the services are performed has the right to control and direct the individual performing the service regarding the results of the work and the measures used to accomplish those goals.

Common Law Rules
Factors that affect the degree of control fall into three categories:

    1. Behavioral: Does the business control or have the right to control what the worker does and how the worker does his or her job?
    2. Financial: Are the business aspects of the worker’s job controlled by the payer? (These include things like how a worker is paid, whether expenses are reimbursed, and who provides tools or supplies, for example.)
    3. Type of Relationship: Are there written contracts or employee-type benefits (i.e. pension plan, insurance and vacation pay)? Will the relationship continue, and is the work performed a key aspect of the business?

A business must weigh all such factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors may suggest that the worker is an independent contractor. There is no “magic” or set number of factors that “make” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors that are relevant in one situation may not be relevant in another.

The key is to look at the entire relationship, consider the degree or extent of the right to direct and control, and then document each of the factors used in arriving at the determinations.

There is a long-standing misconception among employers that anyone paid less than $600 a year may be classified as an independent contractor. In fact, there is no minimum limit on amount of remuneration or number of hours worked that is relevant to classification determination.

What should a business do to prevent or reduce misclassification risks?

One effective approach is a self-audit where the business evaluates its hired help with the assistance of a professional to determine the level of misclassification-related risk.

Businesses that self-identify potential risks are able to initiate appropriate corrective measures. The ability and willingness to self-correct comes with real economic benefits – the costs associated with a self-audit and self-correction plan are likely less than the fines and fees that might result from a single IRS audit or a worker lawsuit for overtime wages, among other claims.

In addition, Section 530 of the Internal Revenue Act of 1978 provides a safe harbor. It states in part that an individual will not be considered an employee if a taxpayer treated him or her and other workers performing similar tasks as non-employees for all periods, had a reasonable basis for doing so and filed required information and other returns consistently with that status. See your legal or tax professional for additional assistance.