Independent Contractor Vs. Employee Status: How To Get It Right
How does a business determine if its workers are employees or independent contractors? This distinction is not as simple as most may think.
The adage, “My workers are subcontractors because they pay their own taxes,” is not one of the 20 questions that the IRS or state labor agencies use to determine worker classification—and that defense would never carry any weight in an employment audit. In an era where worker misclassification and due diligence requirements are at an all-time high, business professionals must understand all the complexities. Improper classification not only carries a huge burden on the business, but can also have a significant impact on the worker.
If the IRS determines employees were erroneously classified as independent contractors, the IRS may notify the workers that they are not entitled to deduct their business expenses from gross income on Schedule C and/or that they were not entitled to contribute to a retirement plan because they are not self-employed. When the IRS prohibits business expense and deduction claims for contributions to self-employed retirement plans, it can be very costly to the worker.
In addition, when a business fails to properly classify its workers as employees, these individuals are unable to participate in benefit programs such as employer-provided health insurance. This issue, which usually arises after the fact, can catch workers by surprise and put them in a predicament that they may not be prepared to resolve.
Yet, the consequences and impact on the business are far greater than those for the misclassified worker. In most cases, businesses categorize workers incorrectly due to lack of knowledge and understanding of the guidelines. However, in some cases the misclassification is clearly willful and negligent. There are only so many employment audits the IRS and state labor agencies can conduct, and when a business that is negligent goes through an audit, the consequences can be quite severe.
For example, a willfully careless business that has misclassified its workers will not only be responsible for the tax liability, the penalty for improper classification and the penalty for failure to file returns, but it will also be responsible for 100 percent of the penalty for willful failure to collect tax. By the time the audit case is closed, a business may owe three times as much just for improperly classifying its workers.
Most employment classification issues occur at the state level. When economic times are tough, workers will apply for unemployment compensation, which triggers the state unemployment office to investigate when it discovers that the business doesn’t have the worker classified as an employee. Other times, employment classification issues are triggered by workers’ compensation claims, or complaints to the state unemployment board about a work-related situation. It’s often the least expected situation that can get a business under fire for worker misclassification.
While it’s quite clear what the consequences are to the business and the worker for improper classification, it isn’t always clear how a business determines if its workers are employees or independent contractors. The key issue that the IRS asks about is whether the business had “control” over the worker, but how control is determined is not always clear.
To determine if a business had control, the IRS will generally consider 20 questions in making the final determination of worker classification. Keep in mind that not all these inquiries apply in every worker classification audit.
Often, the IRS will use only those questions that apply based on the industry the business is operating in. Of these 20 questions, here are nine that most businesses can use to make a fairly safe and correct classification of their workers:
1. Is the worker required to comply with instructions given by the business?
2. Does the business provide the worker with training?
3. Is there a continuing relationship between the business and the worker?
4. Does the business provide set hours of work for the worker?
5. Is the worker required to have substantial hours toward the needs of the business?
6. Who furnishes the worker’s tools and materials to conduct the work?
7. Will the worker realize a profit or loss from the services provided to the business?
8. Does the worker work for more than one business at a time?
9. Does the worker receive payment by the hour, week or month?
When conducting worker classification audits, these are some of the questions that are considered by the IRS and state labor agencies. Worker classification audits are evaluated on a case-by-case basis, so the degree of importance given to the answers of each of the 20 questions will vary depending on the business and its situation.
Remember, too, that IRS or court case rulings on workers' status exist and set precedence in most industries. Therefore, it’s not necessarily where the business thinks their workers should be, but rather what prior case rulings dictate.
Helping your clients understand the guidelines and properly classifying their workers can prevent an audit as well as save the business significant money in penalties and interest. In addition, it can keep you out of the hot seat during these challenging times when the IRS is mandating higher due diligence requirements. There is nothing better than getting it right the first time.
Andrew G. Poulos, EA, ABA, ATP, is principal of Poulos Accounting & Consulting, Inc., in Atlanta, Georgia, where he works with individual and business tax clients, and represents clients before the IRS and state labor agencies. An entrepreneur and real estate investor, Poulos is an author and national speaker. He is a contributing author to Intuit’s News Central website and blog, and founding tax editor for Reviews.com and current tax editor for Consumeraffairs.com. He’s also an analyst for leading news organizations including CBS News, NBC News, Fox News, TIME, Forbes, The Wall Street Journal, U.S. News & World Report and USA Today, among others. He is the producer of the QuickBooks Ultimate Lesson Guide DVD Series and founder of Poulos Children’s Cancer Foundation, a 501(c)3 charity. Contact him at www.savvytaxguy.com.
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