Worker classifications: employee or independent contractor?

Worker classifications are important because, in the words of employee benefits practice attorney Frank Morris, Jr., “Never has the potential peril for misclassification of individuals as independent contractors or employees as exempt been greater.”

Since companies pay less in payroll taxes for independent contractors versus employees, the government is determined and quick to identify mislabeled workers.

The stakes are also getting higher due to several changes in the legislative landscape, such as:

  • Increases in minimum wage – Many jurisdictions are raising their minimum wages above the federal Fair Labor Standards Act (FLSA) $7.25 per hour level. To avoid paying these higher wages, some companies may try to classify employees as independent contractors.
  • Impact of the Affordable Care Act (ACA)– Some companies are attempting to misclassify employees as independent contractors to avoid providing health benefits – or to minimize the amount of penalty they pay under health care reform. But, if caught, they could be stuck with a much bigger bill. The penalty for failure to provide minimum essential health benefits is equal to the number of full-time employees times $166.66 per month for every employee after the first 30 employees. Additionally, there’s an argument that failing to provide required coverage to workers by mislabeling them independent contractors could make the employer liable for any medical claims those workers may later make. If this position is adopted, an employer could face massive bills should an individual have a catastrophic accident or fall ill due to a serious illness.
  • Potential impact of the Payroll Fraud Prevention Act of 2013 – Introduced into the U.S. Senate in November 2013, this act aims to reduce the mislabeling of employees as independent contractors on a federal level. If passed, it would require all employers to issue a notice for both “non-employees” (i.e., independent contractors) and “employees,” telling them how they’re currently classified. The notice would provide contact information for the Department of Labor (DOL) and tell workers that they should be in contact with the DOL if they believe they’ve been misclassified. Noncompliant employers would face substantial penalties.
For these reasons, companies should carefully review their classifications of employees and independent contractors as they enter 2014.

Determining worker classifications

Note: Classifying workers as independent contractors or employees is a complex legal and tax issue. What follows are some general guidelines based on material from the Internal Revenue Service (IRS). Do not underestimate the difficulty of applying these standards to specific individuals. In doubtful cases, always consult a knowledgeable attorney.
Generally, your company must withhold and pay over federal income taxes as well as Social Security and Medicare taxes and pay federal and state unemployment tax on wages you pay to employees. You do not normally have to withhold or pay over any federal taxes on payments you make to independent contractors. Other requirements that apply to employment do not ordinarily apply to contractors such as the requirement to provide workers compensation insurance, wage and hour laws and other employment-related laws. As a result, the temptation to call a worker an independent contractor may be strong, but the risks are high because, where a worker is determined to be an employee who was misclassified, each of these laws can be enforced. For example, the company may owe back taxes plus penalties for failure to withhold.

When evaluating your workers’ classifications, you need to examine your business’ relationship with those workers, paying special attention to your company’s degree of control in the relationship and the workers’ degree of independence.

The IRS encourages you to consider facts related to behavioral control, financial control and the relationship type as a way of testing a worker’s classification.

Behavioral control

Facts that show whether your business has a right to direct and control how the workers in question do the tasks you hired them to do include the type and degree of:

  • Instructions your 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 you have the right to control how the work results are achieved. Your company 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 your business has retained the right to control the details of a worker’s performance or instead has given up that right.
  • Training your business provides to the worker. An employee is more likely to be trained by the employer to perform services in a particular manner. Independent contractors ordinarily use their own methods.

Financial control

Facts that show whether your company has a right to control the business aspects of the worker’s job include:

  • 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 employee usually has no investment in the work other than his or her own time. 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 a requirement for independent contractor status.
  • The extent to which the worker makes services available to other companies. 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 related industry.
  • How your 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 achieve a profit or loss. Since an employer usually provides employees a workplace, tools, materials, equipment and supplies needed for the work, and generally covers the costs of doing business, employees don’t have an opportunity to make a profit or loss. An independent contractor can make a profit or loss.

Type of relationship

Facts that show the company-worker relationship type include:
  • Written contracts describing the business relationship between both parties. This is probably the least important of the criteria, since what really matters is the nature of the underlying work relationship, not what your business and the worker choose to call it. However, in close cases, the written contract can make a difference.
  • Whether your company provides the worker with employee-type benefits, such as insurance, retirement plan, vacation pay or sick pay. The power to grant benefits carries with it the power to take them away, which is a power generally exercised by employers over employees. True, independent contractors will finance their own benefits.
  • The permanency of the relationship. If a worker is expected to continue his or her work indefinitely, rather than for a specific project or period, it’s generally deemed an employer-employee relationship.
  • The extent to which the worker’s services are a key aspect in your company’s regular business. If a worker provides services that are a key aspect of your company’s 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.

5 situations to avoid

The following situations may raise suspicions about how you have classified your workers and could lead to an IRS audit.

  1. Reclassifying employees as independent contractors, especially issuing the same worker both a W-2 and a 1099-MISC
  2. Laying off employees and making them independent contractors so that they can finish up work that needs to be done
  3. Providing most of the supplies that workers need to perform their duties (e.g., laptops, phones, office supplies) and classifying them as independent contractors
  4. Being the only client or source of income for an independent contractor
  5. Making regular, indefinite payments to an independent contractor over multiple years
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One response to “Worker classifications: employee or independent contractor?


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