If your company were to hire a worker, would that person be classified as an employee or an independent contractor?
In today’s business environment, the use of consultants or independent contractors is a common practice. Influential factors driving this trend include the need for specialized expertise for particular projects and the transient nature of most contracts.
Smart Business spoke with Brent Saunier, tax manager at Tauber & Balser, P.C., about misclassifying workers and the consequences with the IRS.
Why are workers misclassified between employee and independent contractor?
Workers are often misclassified as independent contractors because of economics and ease. An organization classifies a worker as an independent contractor because of factors including:
- lower tax liability
- fewer payroll/accounting issues
- not providing benefits
- not paying workers’ compensation insurance.
Why is it so difficult to properly determine this classification?
Although the IRS has specific guidelines on determining the status of a worker, the employer is faced with a great deal of subjectivity in making its determination. No single factor determines whether a worker is an employee or independent contractor.
So how does an employer determine if a worker should be classified as an employee or independent contractor?
Unfortunately, there is no specific definition of an employee from a tax perspective. In making such determinations, the IRS focuses on the concept of control. The IRS issued Revenue Ruling 87-41, which states: Generally, the relationship of employer and employee exists when the person or persons for whom the services are performed have the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished.
Basically, if the control is primarily in the hands of the employer, then the worker is an employee; if the control is primarily in the hands of the worker, then the worker is likely an independent contractor.
Does Revenue Ruling 87-41 provide any further guidance on classifying a worker as an employee versus an independent contractor?
Revenue Ruling 87-41 lists and describes 20 factors to be considered in differentiating between employees and independent contractors. Some factors include:
- Is the worker subject to the employer’s instructions?
- Does the employer provide training?
- Are the services rendered personally by the worker?
- Does a continuing relationship exist?
- Does the employer set hours of work?
- Is full-time work required?
- Is the person doing work on the employer’s premises?
- Is the work order or sequences set by the employer?
- Is payment by the hour, week or month?
- Is the employer responsible for the furnishing of tools and materials?
- Is the individual working for more than one firm at a time?
- Is the individual engaged in making service available to the general public?
These are only some of the factors that the IRS uses to determine worker classification. The more control that an employer has over a worker’s activities, the more the relationship becomes that of an employee-employer rather than an independent contractor.
Could you provide any detail on the potential consequences of misclassifying an employee as an independent contractor?
In the event the IRS disallows an employer’s classification of a worker as an independent contractor, the employer may be subject to the following assessments:
- 7.65 percent of the worker’s pay
- (employer share of the FICA tax)
- Additional tax in the amount of 20 percent of the worker’s share of FICA and Medicare taxes.
- Additional tax in the amount of 1.5 percent of the worker’s federal withholding taxes.
- FUTA tax, typically in the amount of 6.2 percent of the worker’s pay up to $7,000 per worker.
- Additional penalties. The bill for IRS back taxes and related interest and penalties can be a minimum of 10.68 percent of the employee’s back pay. Criminal penalties may be enforced.
- Interest expense. The rate of the fedeal short-term rate plus 3 percent.
Remember, the key is control, or the right to control, over the details and means by which a service is accomplished. The more control, the better the likelihood that the worker is an employee. If a worker is subject to control the result of the work, the worker will probably be considered an independent contractor.
Depending on the number of individuals that you wish to classify as an independent contractor, you should consider getting an opinion letter from your tax professional supporting your position. An opinion letter could prove to be very beneficial if the IRS were to come calling.
BRENT SAUNIER, CPA, is a tax manager at Tauber & Balser, P.C. with more than 10 years of experience in accounting operations and financial management. He has worked extensively in industries such as distribution, health care, manufacturing, professional services, retail service and trucking. Reach him at (404) 814-4960 or firstname.lastname@example.org.