What Every Business Needs to Know
The distinction between “employees” and “independent contractor” is significant when it comes to the responsibilities of the business towards that person. Employers must withhold income taxes from employees paychecks, Social Security and Medicare taxes, and unemployment taxes on wages paid to an employee, and generally do not have these responsibilities towards independent contractors.
Because having an employee is more expensive and carries more responsibility, the temptation is often to classify as many workers as possible that way. Small and young businesses with tight budgets can be especially susceptible to these temptations. However this is a risk that can be dangerous.
Once a business hires or contracts with other individuals to provide services, they have a duty to determine if those individuals are employees or independent contractors. Determining whether persons are employees or independent contractors is an important business decision, and must not be made thoughtlessly. If the individual is an employee then the business owner is an employer, a status which carries with it many duties, both to the employer and the IRS.
How Do I Know If Contractors Should Be Considered Employees?
The right to direct or control the worker's work is the primary consideration in determining the difference. Always a valuable resource is the IRS website, which defines independent contractors. It states that “the general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”
The IRS also has a 20-factor analysis you can use to assist you in making a determination. For a more comprehensive look at the 20-factor analysis, check out
Proper classification requires that a business follow detailed criteria to distinguish between employees and independent contractors. The IRS and the various state tax agencies rely upon “common law” rules to distinguish employees from independent contractors. Common law generally refers to rulings that are made by judges rather than laws passed by legislature. Both are valid forms of binding laws.
Under common law rules, workers are employees if the employer has the right to direct and control them in the way they work, both as to the final results and as to the details of when, where, and how their work is done. Even workers with broad discretion in determining how they do their work are common-law employees if the employer has ultimate control over their activities and the final product of their work.
There is no widely accepted, clear definition of where the line of control lies to cause a worker to be classified as an employee rather than an independent contractor. The decisions are made on a case-by case analysis. Furthermore, the decisions are made based on what is called a “totality of the circumstances” standard. This means that each fact is looked at in the context of the broader relationship. Therefore a good starting point is to examine the nature of the relationship itself..
A Signed, Written Contract Will Not Save You From a Misclassification
Many employers hold the misconception that they can avoid incurring payroll tax obligations simply by having a worker sign an agreement declaring that they are an independent contractor. It is generally true that two parties can make contractual agreements freely, however such clauses carry little significance under the common-law rules.
It is most unwise to rely exclusively on a contract for a worker classification. Just take an honest look at the business’s professional relationship with a person. If the dynamic is that of an employer and an employee, then the IRS and the courts will see them as employees regardless of how they might be described in a contact.
Safe Haven for Proper Classification of Workers
The tax law provides a safe haven rule that, for some employers, can minimize uncertainty when it comes to the proper treatment of workers as employees or independent contractors for purposes of employment taxes. If you meet the terms of the rule, your characterization of an individual as an independent contractor will not be challenged.
We will discuss the safe haven rule in greater detail in an upcoming article.
Requesting a Worker Classification Ruling From the IRS
You might be thinking that the rules described above seem awfully subjective. Unfortunately, you’re right. Even more unfortunately, a tax auditor will often look at the same set facts and see an employee where a business owner sees an independent contractor.
To be safe, the best bet is to speak to a tax professional before taking the position that any of workers are independent contractors. In close cases, requesting an IRS determination as to a worker's proper classification can be a useful tool. If the IRS is going to disagree with your classification, you can save a lot in tax penalties, interest, and legal costs by finding that out sooner rather than later.
Don’t Delay, Consult The Tax Lawyer
The IRS considers improper classification of an employee as an independent contractor to be an area of significant noncompliance. Every year the federal government loses billions of dollars in tax revenue as a result of this practice. Accordingly, they are ramping up efforts to bring noncompliant business to justice, including with criminal penalties. If you’re currently undergoing an IRS audit involving worker classification issues, the best thing you can do is retain experienced legal counsel and be very cautious in how you respond to the IRS.
Tax Attorney, William D Hartsock has been successfully helping clients resolve business tax issues and payroll tax matters since the early 1980's. Mr. Hartsock offers free consultations with the full benefit and protections of attorney client privilege to help people clearly understand their situation and options based on the circumstances of their case. To schedule your free consultation simply fill out the contact form found on this page, or call (858)481-4844.