Not just a Title
What is the difference between an independent contractor or an employee? Are we just splitting hairs over what term to use when referring to workers? As it turns out, this is one of the most significant and most consequential distinctions in employment law, and the IRS certainly cares about putting workers in the correct category.
Whether your workers are independent contractors or employees determines:
- How they are paid;
- What benefits, if any, they receive; and
- Their IRS tax status.
Any business owner should treat this distinction seriously, knowing that haphazardly slapping labels on their workers is risky when the federal government gets involved.
Why Worker Classification is Important
Proper classification is essential for businesses because it determines how the company will pay the worker and what the business owes the federal government. Employers have to withhold federal income taxes, and state and municipal taxes in certain places, from wages paid to employees. Employers must also pay Social Security, Medicare, and unemployment taxes on employee wages. The IRS collects these funds to ensure that these federal programs can continue to operate. In addition, businesses must pay employees set minimum wage and overtime rates and provide certain fringe benefits like healthcare and paid time off.
Conversely, an employer does not have to deal with the pesky task of withholding or paying taxes on wages paid to an independent contractor. Instead, the independent contractor must calculate how much they owe federal and state governments and make those payments on a quarterly basis. Also, businesses are not obligated to provide independent contractors fringe benefits, which can save employers a lot of money on healthcare and other benefits. Finally, companies do not have to worry about complying with overtime pay laws when dealing with independent contractors.
You might wonder why don't businesses just try to classify more workers as independent contractors? The answer is that misclassifying workers as independent contractors invites the wrath of the federal government and the legal system. Furthermore, don't expect the government to just take your word for it on your classifications. The U.S. Department of Labor has increased the frequency of their random audits of businesses. Perhaps for a good reason: an estimated 3.4 million employees are misclassified as independent contractors.
This, in turn, hurts the government's ability to operate these necessary programs. It has been estimated that misclassifications cost the United States $54 billion in underpayment of employment taxes and $15 billion in unpaid FICA and unemployment.
Misclassification: A Problem to Avoid
Employers that misclassify employees as independent contractors may be required to pay back unemployment, worker's compensation, and social security taxes, as well as the federal and state income tax withholding that should have been taken out of the employee's wages. At the very least, if the misclassification was unintentional, the employer will be subject to the following penalties, based on the fact that all payments to misclassified independent contractors have been reclassified as wages:
- $50 for each W-2 form that the employer did not file because of misclassifying the employee as an independent contractor;
- A penalty of 3% of employee's wages, plus 40% of FICA taxes (Social Security and Medicare) that were not withheld from paychecks and 100% of the matching FICA taxes that the employer was responsible for. Interest also accrues daily on these penalties from the date they were due; and
- A Failure to Pay Taxes penalty equal to 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability.
The IRS can assess additional fines and penalties when fraud or intentional misconduct is suspected. For example, an employer found liable for intentionally misclassifying employees can be subject to penalties including 20% of all wages paid, plus 100% of the FICA taxes, on both the employee's and employer's share. Furthermore, criminal penalties of up to $1,000 per misclassified worker and one year of prison can be added to an employer's misfortunes. The person responsible for ensuring payroll taxes are withheld can also be held personally liable for uncollected taxes.
Those are just the penalties a company could face from the IRS; it can get much worse. A federal or state labor agency could prosecute a company under the Fair Labor Standards Act, resulting in an employer being assessed penalties for unpaid overtime and minimum wage deficits. Employers that withhold worker's compensation from misclassified employees violate state workers' compensation insurance laws and pay back premiums. Finally, employers might be forced to repay fringe benefits that were wrongfully withheld, including pension, health insurance, and paid leave.
The cost of paying back taxes for unemployment, penalties, and other fees for misclassification can cripple a small business. Businesses should also realize that misclassification has severe consequences for the worker as well. Independent contractors are ineligible for unemployment benefits and workers' compensation. Misclassification can be a costly, crippling mistake. There are several guidelines and tips to help avoid making the wrong decision.
IRS Classification Guidance
Luckily, the IRS has provided guidance documents online to help businesses make the correct classification choice of independent contractor or employee. The IRS uses three categories when determining proper classification: Behavioral Control, Financial Control, and Relationship of the Parties.
Behavioral Control: This category asks whether the business has the right to direct and control how the worker performs the job. The types of instructions given, such as when and where to work, are considered. The more detailed the instructions provided, the more likely the worker is an employee and vice versa. Evaluation systems used to measure job details indicate an employee, whereas evaluation systems only evaluating the end result more likely point to an independent contractor. Periodic or ongoing training about methods used to perform the job is considered strong evidence that the worker is an employee.
Financial Control: This category looks at whether the business determines the financial aspects of the worker's job. Independent contractors are more likely to incur unreimbursed expenses and to supply their own equipment. Also, independent contractors will have an opportunity for profit or take on some risk of loss in their jobs. Method of payment is a crucial indicator of financial control. Employees are usually paid a regular wage on a specific basis; independent contractors are frequently paid flat fees for jobs.
Relationship: The last category focuses on how the worker and business perceive their interaction. Written contracts that describe the relationship are considered, but not determinative, in the proper classification. If the company provides benefits to the worker, then the worker is most likely an employee. Permanency of the relationship can indicate an employee when the employment relationship is expected to continue indefinitely, rather than for a specific period or project.
The IRS is not the only federal government body that has issued guidance about this issue. The Department of Labor uses the “Economic Realities Test” under the Fair Labor Standards Act influenced by Supreme Court precedent. Six factors are evaluated to determine whether a worker is an independent contractor or employee:
- The extent of the work performed as an integral part of an employer's business
- The worker's opportunity for profit or loss
- The extent of relative investments of employer and worker
- Whether the work requires special skills or initiative
- The permanency of relationship
- The degree of control employer exercises or retains
Some states follow the "Economic Realities Test" or a closely related "right to control" test. About one-third of states use the "A-B-C Test," including California. This test simplifies the analysis by adopting a bright-line rule that any worker is considered an employee and not an independent contractor unless:
(a) the worker is free from control and direction in performing work, both under the contract for the performance and in fact;
(b) services are performed outside of the employer's usual course of business; and
(c) the worker is engaged in an independently established trade, occupation, profession, or business of the same nature as that involved in the service performed. This means a worker must meet all three parts of the ABC Test to be an independent contractor.
Check to see what classification method your state follows as ABC states, like California, will be more likely to scrutinize independent contractor classifications as the ABC Test is considered stricter than the others. With all this being said, there are some common mistakes to avoid when deciding whether a worker is an independent contractor or employee.
Over-reliance on Written Contracts
Do not fall into the trap of thinking that the IRS will automatically take your word for it when you put an independent contractor clause in an employment contract and refer to an employee as one. The IRS explicitly warns on their website that contractual arrangements are not sufficient to determine a worker's status. Moreover, the IRS is not required to follow contracts stating the worker is an independent contractor but instead follows how the parties work together to determine the worker's classification. Put whatever you want in an employment contract, but the proof will be in the pudding.
Misinterpreting what a “significant investment” means
Usually, independent contractors have a significant investment in their equipment when working for someone. However, beware that in many occupations, such as construction, workers spend thousands of dollars on tools and equipment and are still considered employees. Also, if you simply reimburse the worker for expensive purchases they make, that doesn't qualify as a significant investment. The IRS admits that no exact dollar limit qualifies as a significant investment. Moreover, significant investments are not required for independent contractor classification when the work's nature does not demand large upfront or fixed costs. Therefore, context matters on this issue.
We recognize that it may be frustrating that there is no clear answer about what a significant investment is. It is vital to consult with an experienced law firm that can help you determine what a significant investment is in relation to your business or your work as an independent contractor.
Paying Employees and Independent Contractors Similarly
As discussed before, employees are paid a set wage on a weekly or monthly basis, whereas independent contractors are paid based on job completion. Confusion and Issues might arise when you start paying your independent contractors an hourly rate because a set wage might imply other things about the employment relationship, like that the employer is dictating the worker's schedule. While other aspects of the worker's relationship might save the employer from punishment courtesy of the IRS, it is best to implement different compensation schedules for employees and independent contractors to avoid tricky situations down the road.
Take Time to Make the Right Choice
When making the critical decision on whether a worker is an employee or independent contractor, take a step back and analyze your relationship with the worker holistically. The key factor to think about is the degree of control. Remember, the worker has to be an independent contractor. Check your state law to determine what test your state uses, as the ABC test is a bit stricter than the others. Devote adequate time to make the right choice because the consequences of getting it wrong can be incredibly costly and embarrassing for your business.
Contact Us Today
Have any questions on classifying independent contractors and employees? Contact the knowledgeable lawyers at Newburn Law today so that we can answer any questions you might have.