Independent Contractors versus Employees

States, the IRS and the DOL are focused on the classification of workers.  
With permission from Jeff Matthews, CPA, CGMA

 

 

 

 

Thirty states have worker classification rules and they believe they are missing out on state income tax revenue and workers compensation fees.  They also believe that workers are being left uncovered for unemployment purposes.  These efforts are on top of the IRS and federal DOL enforcement of workers classification rules.  For perspective, consider that in 2012 New York State found 20,200 workers incorrectly treated as independent contractors which represented more than $282 million in unreported wages.

The penalties can be substantial.  An unfavorable ruling results in reclassification as employees triggering unreporting penalties on federal and state income tax withholding, employer and employee FICA and Medicare taxes, interest, federal and state unemployment taxes and possible issues under the Affordable Care Act (ACA).  While the ACA employer mandate has been delayed until 2015, you can expect that the enforcement agencies will continue to scrutinize this issue in 2014.

Common law principles have long been used to define the employee/employer relationship.  These rules focus on three areas: behavioral aspects, financial aspects and on the type of relationship.  The IRS’s website states, “the keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.”

Behavioral factors focus on the right to direct the workers activity.

  • What type of instruction is provided by the employer
  • What evaluation systems are used
  • Where is the work to be performed
  • Whether the worker can hire others and who pays those workers
  • If the worker provides supplies and tools
  • Whether the worker is trained at the firm’s expense. [1]

Financial factors focus on the risk to the worker of profit or loss. 

  • Does the worker have to make a significant investment in tools, equipment and specialized training?
  • Does the worker incur unreimbursed expenses in connection with the service?
  • Is the worker free to obtain additional clients and to seek out business opportunities with others?
  • How is the worker compensated?  An independent contractor may be paid a flat fee for a job or charge an hourly rate.  Employees are typically paid a regular salary, commission or hourly rate. [2]

The type of relationship focuses on whether there is a written contract and whether employee benefits are provided.  While some contracting firms have pooled their contractors and provide worker paid health care and insurance, most benefits are provided to employees.  The presence of a written contract may not be a litmus test but whether the relationship continues beyond a project is a critical test.  Do the parties expect the relationship will continue indefinitely or to end after a specific period or project?

An independent contractor normally does not rely on a single source of revenue; they work under their own direction and have elements of profit and loss risk.  Independent contractors are expected to be prepared to do the work requiring minimal orientation and training.  Employees depend upon a business for a steady income, do not control the timing and flow of their work and work within the constraints of the employer.

As an employer if you utilize independent contractors, familiarize yourself with the rules and document your decision process.  Then periodically revisit the decision to ensure that the relationship has not morphed into an employee relationship.

The team at ASBC is always here to answer any and all questions about employee classifications and any other business-related issues. Give us a call today to make sure you’re aware of all the regulations and requirements regarding your employees and contractors!

[1] Independent Contractor (Self-Employed) or Employee? Retrieved Ocotber 27, 2013, from http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-(Self-Employed)-or-Employee
[2] Independent Contractor (Self-Employed) or Employee? Retrieved Ocotber 27, 2013, from http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-(Self-Employed)-or-Employee

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