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How To Classify Workers and Avoid Crippling IRS Penalties
"Independent Contractor" vs. "Employee"
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NIGHTMARE SCENARIO:
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Consider the following possibility. The IRS audits a small business and then determines that its owes over $28,000 in back taxes plus over $10,000 in penalties. They give the business 10 days to pay. They did this because the business had for several years retained a person to perform services and had chosen to treat the person as an independent contractor rather than as an employee (with the business thus being able to avoid paying its one-half share of the worker's FICA taxes and dumping the entire burden for paying those taxes upon the "self-employed" worker). In reaching its determination the IRS disregarded how the business classified the person and, instead, made an independent determination that the person was really an employee.
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When the IRS determines that an individual is really an employee and not an independent contractor they can make the business pay all of the unpaid payroll taxes going back to the date that the worker was first retained. They can also assess penalties. A business with an "employee" must pay one half of the medicare, social security, and unemployment taxes (FICA) owed for that person and must withhold the other half from the employee's paycheck and deposit it with the IRS. Upon reclassification the IRS will also send a notice to "employee" notifying him or her of the reclassification and stating that proof must be submitted that he or she paid taxes based upon being an "employee" and not as an "independent contractor". If this cannot be proven to the satisfaction of the IRS the "employee" may have to also pay the back taxes plus penalties.
The "Common Law Rule" Applied by the IRS
in Determining Status
The IRS applies what it considers to be the "common law" in determining the classification of workers. IRS Revenue Ruling 87-41 spells out twenty common law factors that are to be considered (CLICK HERE to view the 20 factors). The IRS published these so that employers could correctly classify workers as employees or independent contractors and also to help independent contractors determine if they've been correctly classified or not.
To determine whether an individual is an employee or an independent contractor under the common law, the relationship of the worker and the business must be examined. All evidence of control and independence must be considered. In any employee-independent contractor determination, all information that provides evidence of the degree of control and the degree of independence must be considered. Facts that provide evidence of the degree of control and independence fall into three categories:
- behavioral control
- financial control, and
- the type of relationship
Behavioral control: 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' instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work:
- When and where to do the work
- What tools or equipment to use
- What workers to hire or to assist with the work
- Where to purchase supplies and services
- What work must be performed by a specified individual
- What order or sequence to follow
- The amount of instruction needed varies among different jobs. 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. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker's performance or instead has given up that right.
- 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.
- The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than are 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 in connection with the services they perform for their business.
- The extent of the worker's investment. An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.
- The extent to which the worker makes services available to the relevant market. An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.
- How the business pays the worker. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.
- The extent to which the worker can realize a profit or loss. An independent contractor can make a profit or loss.
Type of relationship: Facts that show the parties' type of relationship include:
- 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.
- The permanency of the relationship. If you engage a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that your intent was to create an employer-employee relationship.
- The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of your regular business activity, it is more likely that you will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney's work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.
IRS help. If you want the IRS to determine whether a worker is an employee, file Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS. Click Here to go to the IRS's download page. Hint: to open the link in a new (full) window, click your mouse's right hand button on the link and choose the appropriate choice.
