The misclassification of independent contractors isn’t a problem just during tax season, as state unemployment compensation and workers’ compensation offices increasingly are acting year-round as “the eyes and ears” of the Internal Revenue Service (IRS), (according to Ronald E. Wainrib, president of Ronald E. Wainrib & Associates in Franklin, Mass.) The phrase “1099 workers” is a shorthand reference to independent contractors, and refers to a federal tax form (Form 1099-MISC, rather than the W-2) used by employers to report payments to independent contractors.
Many companies have fallen into the most common time for misclassifications – which occurs when an employee leaves a position on good terms and then fills in on a temporary basis as an “independent contractor” for a month or two while the employer searches for a replacement. The worker often ends up doing exactly what the person did as an employee. One month turns into two, then four, and before long the employer is not working as hard to fill the position. The question then arises whether the person is classified properly.
Patterns can be difficult to change, but it is up to the employer to communicate and act clearly if they want to make someone an independent contractor who in the past was an employee. That person no longer should be:
- Attending team meetings
- Be going into an office regularly
- Be expected to work certain hours
Also, the individual:
- Shouldn’t have company business cards
- Shouldn’t be referred to as an employee
The IRS views a status that switches from Employee to Contractor or Contractor to Employee to both be red flags for tax fraud, and possible FLSA violations. Either way, an IRS and/or FLSA audit may be triggered, resulting in additional tax and penalties – not to mention the inconvenience of your business interruption to facilitate the audit and address the issues. Penalties for one misclassification may be thousands of dollars depending on the length of time and the amount of pay.
As a small business owner you may hire people as independent contractors or as employees. There are rules that will help you determine how to classify the people you hire. This will affect how much you pay in taxes, whether you need to withhold from your workers paychecks and what tax documents you need to file.
Here are seven things every business owner should know about hiring people as independent contractors versus hiring them as employees. (From IRS Summertime Tax Tip 2010-20)
- The IRS uses three characteristics to determine the relationship between businesses and workers:
- If you have the right to control or direct not only what is to be done, but also how it is to be done, then your workers are most likely employees.
- If you can direct or control only the result of the work done — and not the means and methods of accomplishing the result — then your workers are probably independent contractors.
- Employers who misclassify workers as independent contractors can end up with substantial tax bills. Additionally, they can face penalties for failing to pay employment taxes and for failing to file required tax forms.
- Workers can avoid higher tax bills and lost benefits if they know their proper status.
- Both employers and workers can ask the IRS to make a determination on whether a specific individual is an independent contractor or an employee by filing a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS.
- You can learn more about the critical determination of a worker’s status as an Independent Contractor or Employee at IRS.gov by selecting the Small Business link. Additional resources include IRS Publication 15-A, Employer’s Supplemental Tax Guide, Publication 1779, Independent Contractor or Employee, and Publication 1976, Do You Qualify for Relief under Section 530? These publications and Form SS-8 are available on the IRS website or by calling the IRS at 800-829-3676 (800-TAX-FORM).
- Behavioral Control covers facts that show whether the business has a right to direct or control how the work is done through instructions, training or other means.
- Financial Control covers facts that show whether the business has a right to direct or control the financial and business aspects of the worker’s job.
- Type of Relationship factor relates to how the workers and the business owner perceive their relationship.
Publication 15-A, Employer’s Supplemental Tax Guide (PDF)
Publication 1779, Independent Contractor or Employee (PDF)
Publication 1976, Do You Qualify for Relief under Section 530? (PDF)
Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding (PDF)
Legal Disclaimer: This article is intended for informational purposes only and by no means should replace or substitute other legal documents (governmental or non-governmental) reflecting similar content or advice. If you have any questions concerning your situation or the information provided, please consult with an attorney or an HR Professional.