“Never has the potential peril for misclassification of individuals as independent contractors or employees as exempt been greater,” says employee benefits practice attorney Frank Morris.
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:
• Impact of the Affordable Care Act – 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 if such an individual has, for example, a catastrophic accident or 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.
Classification: employee or independent contractor?
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.
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:
o What tools or equipment to use
o What workers to hire or to assist with the work
o Where to purchase supplies and services
o What work must be performed by a specified individual
o What order or sequence to follow
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 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
• 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 red flags to avoid
The following situations may raise suspicions about how you have classified your workers and could lead to an IRS audit.
• Providing most of the supplies that workers need to perform their duties (e.g., laptops, phones, office supplies) and classifying them as independent contractors
• Being the only client or source of income for an independent contractor
• Making regular, indefinite payments to an independent contractor over multiple years