Employee vs. Independent Contractor
When you hire someone, you must decide whether to classify them as either an “Employee” or an “Independent Contractor” (“IC”) for tax and other purposes. There is no uniform guidance to definitively distinguish between an Employee and an IC. Instead, various state and federal government agencies have their own rules on how to classify a worker. For example, the IRS may classify a worker as an Employee while your state’s labor department or unemployment agency may classify that same worker as an IC. Simply calling someone an IC, or an Employee will not suffice.
This blog will address only the factors the IRS considers when determining a worker’s status and the risks associated with misclassification. The risks are significant, so it is important to learn the rules before you hire. Some states, like California, are aggressively cracking down on worker misclassification. Consult with a local employment attorney for advice on your state’s specific requirements.
If the worker is classified as an Employee, the Employer must pay half of their Social Security and Medicare taxes, as well as workers compensation and unemployment insurance covering the Employee. Additionally, Employees are entitled to various benefits like paid leave, access to an ADA compliant workplace, overtime pay, group health insurance, and more.
ICs are not entitled to any of the above-mentioned benefits, and the “hiring agent” is not responsible for paying income, Medicare, or Social Security tax. By definition, the IC is their own boss, and they are responsible for their own taxes and benefits. For this reason, it may be tempting to classify the worker as an IC. If you do, you may be asked to pay a little extra, since ICs often charge a higher rate to cover these additional costs.
The IRS Test
When determining whether a worker is an Employee or an IC the IRS will focus on the degree of control the hiring agent has over the worker. The IRS balances three factors in making this determination: (1) behavioral control; (2) financial control; and (3) the relationship between the parties.
The IRS defines a worker as an IC 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.” Said differently, if the hiring agent only cares about the end result and has no control over how the result is achieved, the worker is more likely to be classified as an IC
Conversely, the IRS defines a worker as an Employee if the “employer has the legal right to control the details of how the services are performed.” Said differently, if the hiring agent has the right to control the worker with regards to both the end result, and how it is achieved, then the worker is more likely to be classified as an Employee. Of course, many Employers delegate tasks and need not hover over the shoulders of every Employee. Therefore, the IRS says a worker may be classified as an Employee even if they are given “freedom of action.”
“Control” is subjective and difficult to quantify. The following chart shows how the IRS will weigh certain factors that show control (or lack thereof).
TABLE IN PROGRESS
| Financial Control | Pays the worker hourly or salary | Pays the worker a specified amount for a specific task |
| Reimburses business and travel expenses | Does not pay business and travel expenses | |
| Restricts the worker from working with other businesses | Does not care if worker has other clients | |
| Provides tools and equipment for the job | Requires worker to supply tools and equipment | |
| Behavioral Control | Designates where the work must be completed | Gives worker discretion regarding where work will be completed |
| Provides worker with on-the-job training | Hires worker because of their skill and does not provide additional training | |
| Column 2 | Column 3 | |
| Column 2 | Column 3 |
Consequences of Misclassification
Statute of Limitations: Worker misclassification audits are subject to the usual three-year IRS statute of limitations.
Income Tax: Employer will pay a fine of up to 3% of the wages paid to the worker plus $50 for each Form W-2 the employer failed to file on the Employee.
Social Security and Medicare (FICA taxes): Employers and Employees split FICA taxes evenly. Each is responsible for paying 6.2% for Social Security (12.4% total) and 1.45% for Medicare (2.9% total). If the worker is classified as an IC, the hiring agent does not pay anything (i.e., saves 7.65% of the worker’s wages), and the IC is responsible for paying the full amount of the FICA taxes. Misclassification subjects the hiring agent to a penalty up to 40% of the FICA taxes that should have been withheld from the worker’s paycheck and up to 100% of the matching FICA taxes the employer should have paid.
Healthcare and Retirement Benefits: As stated above, Employees are entitled to certain fringe benefits provided by their Employers, and ICs are not. If a hiring agent misclassifies a worker as an IC, the hiring agent may be required to reimburse the worker for regular and overtime wages in addition to other fringe benefits that should have been provided.
Safe Harbor Provisions
Section 530 of the Internal Revenue Code provides a safe harbor against tax liability for taxpayers whom the IRS determines misclassified a worker. To qualify for this safe harbor provision, the taxpayer must meet three requirements: (1) reporting consistency; (2) substantive consistency; and (3) reasonable basis.
Reporting Consistency: The taxpayer must have timely filed the requisite information returns consistent with its treatment of the worker as an IC (i.e., 1099)
Substantive Consistency: The taxpayer or predecessor must have treated the worker (or any worker holding a substantially similar position) as an IC. If they (or any similar worker) were ever treated as an Employee, the safe harbor provision will not be available. This is a factual determination, and the IRS will evaluate the worker’s job functions and duties. Similar job titles alone will not suffice.
Reasonable Basis: The taxpayer must have reasonably relied on one of the following to form a reasonable belief that the worker was properly classified: (1) prior audit that did not raise an issue with classification, (2) past case law, or (3) industry practice (i.e., everyone in your industry classified similarly situated workers as ICs.
Further safeguards: If you want to be sure that your worker is properly classified, the IRS allows taxpayers to file Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) to receive a determination as to whether a worker is an Employee or IC.
Eric Meleney
Attorney at Law
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Collier & Associates Co., L.P.A
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