How to properly classify workers and avoid IRS headaches Featured

9:59pm EDT April 30, 2013
Jim A. Forbes, CPA, Principal, Skoda Minotti Jim A. Forbes, CPA, Principal, Skoda Minotti

The IRS has a complicated set of guidelines for determining whether a worker should be treated as an employee or independent contractor for payroll tax purposes. It may be tempting for business owners to just classify people as independent contractors and save payroll taxes, but it’s not worth the risk, says Jim Forbes, CPA, a principal with Skoda Minotti.

“The IRS is conducting more payroll tax audits of small businesses, but the risk is always there with any audit. No matter what triggers the audit, the IRS will ask for all of your W-2s and 1099s and will be suspicious if a contractor is being paid like an employee,” Forbes said.

Smart Business spoke with Forbes about the process of determining whether a person is an employer or an independent contractor and why it poses such problems for businesses.

How do you determine if a worker is an employee or independent contractor?

The IRS uses 13 factors; some employers will look at a couple and think a person is clearly an employee or a contractor, but you have to look at all 13. Even then, there’s no set number you have to pass, it’s all a matter of facts and circumstances. That’s why it’s tricky for companies to figure out how to classify workers.

The 13 factors are:

• Type of instructions given. An employee is generally subject to follow instructions about when, where and how to work.

• Degree of instruction. The key consideration is whether the business retains rights to control details of a worker’s performance.

• Evaluation system. If the system measures details of how work is performed, that points to the person being an employee.

• Training. On the job training indicates a particular way of performing the job is desired and is strong evidence the worker is an employee.

• Significant investment. Independent contractors often have invested in the equipment used for work. However, that is not required for independent contractor status.

• Unreimbursed expenses. Independent contractors are more likely to have unreimbursed expenses.

• Opportunity for profit or loss. Having the potential of incurring a loss indicates a worker is an independent contractor.

• Services available to market. An independent contractor is generally free to seek out business opportunities.

• Method of payment. An employee is generally guaranteed a wage for hourly, weekly or other period of time. Independent contractors are usually paid a flat fee for jobs.

• Written contracts. The IRS is not required to follow a contract stating that a worker is an independent contractor; how the parties work together determines how the worker is classified.

• Employee benefits. Insurance, pension plans and other benefits are generally not given to independent contractors. However, absence of benefits does not necessarily means the worker is an independent contractor.

• Permanency of the relationship. If a worker is hired for an indefinite time, that is generally considered evidence of an employee/employer relationship.

• Services provided as a key activity of the business. Companies are more likely to have the right to control activities when the services are a key aspect of the business.

Why would companies attempt to classify employees as independent contractors?

With smaller companies, there is a greater impact from the additional payroll taxes. If the person is an employee, you have to pay 7.65 percent payroll taxes for Social Security and Medicare. There are other taxes, including unemployment, but that is the primary motivation.

There could be more incentive in 2014 with the employer mandate under health care reform. A business with 49 employees that needs to add two more people might want to bring them on as independent contractors to avoid the rules that kick in when you reach 50 full-time equivalents.

Still, most companies will try to do the right thing; it’s just difficult sometimes to figure out what that is. You can meet 10 of the 13 tests, but there’s no guarantee that means the person is an independent contractor. Ultimately, that answer rests with the IRS.

Jim Forbes, CPA, is a principal at Skoda Minotti. Reach him at (440) 449-6800 or jforbes@skodaminotti.com.

Follow up: If you’d like to schedule a confidential consultation regarding employee classification concerns, call Jim at (440) 449-6800.

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