One question our clients frequently ask when compensating a worker for their service: “Is this person an employee, or is he/she an independent contractor?”
Many business owners would incline to classify a worker as an independent contractor instead of employee because, in doing so, they can eliminate the following expenses:
- Payroll taxes
- Overtime and minimum wage payments
- Federal and State unemployment tax
- Worker’s compensation premiums
- Other employee benefits
Federal employment withholding taxes represents significant portion of the IRS revenue. For this reason, the IRS and Department of Labor (DOL) have recently re-energize their efforts to challenge worker classification. Additionally, we see an increased cases of class action suit against putative employers by individuals who were classified as independent contractors but who believe they should have been classified otherwise.
Federal penalties for worker misclassification can be severe, depending on whether the misclassification was unintentional, willful, or fraudulent. If the IRS suspects intentional misconduct or fraud, it can impose additional penalties such as 20% of all the wages paid plus 100% of the FICA taxes (both the employer and employer’s share). There’s also the possibility of criminal penalties and prison sentence. The persons responsible for withholding payroll taxes may also be held personally liable for any uncollected or unremitted tax.
Federal and state jurisdictions apply the following tests in defining independent contractor status:
Common Law Test:
The common law test uses 20 factors to evaluate right of control and the resulting validity of the classification. These factors include level and instruction, amount of training, degree of business integration, and extent of personal services, just to name a few.
IRS Three-Factor Test:
IRS now groups the above 20 factors into three categories:
- Behavioral: Does the company control, or have the right to control, what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? These include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.
- Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
There is no “magic” or set number of factors that makes the worker an employee or an independent contractor, nor does one factor stand alone in making this determination. The keys are to look at the entire relationship, consider the degree or extent of the right to direct control, and to document each of the factors used in coming up with the determination.
Overriding Federal Statutory Provisions:
A worker classification audit by the IRS or a state department of revenue often results from an investigation by the DOL or its state counterpart. The DOL often applies an “economic realities test” which uses the following six factors to determine if a worker is an employee or an independent contractor:
- The degree to which the functions of the worker are essential to the business operations
- The ongoing nature of the relationship between the worker and the employer
- The extent to which the worker has invested in her own materials and supplies
- The control the employer has over the worker
- The degree to which the employer affects the profit and loss opportunities of the worker
- The level of skill, judgement, and initiative required for the functions performed by the worker
The Voluntary Classification Settlement Program provides an option for an employer to reclassify certain classes of its workers as employees, but on a prospective basis. To participate in this program, an employer must meet certain eligibility requirements; file Form 8952, Application for Voluntary Classification Settlement Program; and enter into a closing agreement with the IRS.
Employers should think carefully about entering into a long-term independent contractor relationship. They should be periodically reviewing the requirements for an employee versus an independent contractor since the relationship may change over time. Employers may also want to consider executing a separate contract with an independent contractor for each project completed.