Classifying workers appropriately is an important risk management activity for any business. According to the Houston CPA Society, employers who misclassify employees as independent contractors may find themselves liable for back payments of employment taxes in addition to stiff penalties and interest payments. In some cases, an employer could be required to provide retroactive benefits, such as vacation pay and retirement plan contributions, to a misclassified worker.
An Internal Revenue Service investigation of a firm's worker classifications can result from either a random audit of the firm or from a triggering event. For example, a worker applying for unemployment benefits or filing a worker compensation claim could challenge his or her classification. To protect one's business, it's important to understand how the IRS classifies employees and independent consultants.
There is no single test for classifying workers as independent contractors or employees. However, level of control is a key factor. According to the IRS, a worker is an employee if the company he or she works for has the right to control when, where, and how to do the assigned task. Independent contractors are not “controlled” by the companies that hire them. Although the firm decides what needs to be done and the due date, it is up to the independent contractor to decide the means by which the job is accomplished. Contractors typically work for a number of different companies and may hire others to work on the assignment. Employees, on the other hand, usually work for one employer and have set hours of work.
While the most important factor is control, the IRS uses a list of 20 factors to determine a worker's status. According to this list, these are characteristics of independent contractors: setting their own work hours; furnishing their own tools; not receiving training from the hiring firm; working for more than one firm at a time; being paid by the job rather than by the hour; not providing progress reports; making their services available to the general public; and paying for their own business and travel expenses.
No single factor is determinative. They can carry different weights, and the IRS applies them on a case-by-case basis. For more information, refer to IRS Publication 15-A, Employer's Supplemental Tax Guide. It is available through the IRS Web site at www.irs.gov.
A IRS Section 530 “safe harbor” rule exempts some workers from the 20-factor test. To qualify, the hiring company must meet all three of these requirements: (1) the company has a reasonable basis for classifying the workers as independent contractors; (2) the company has consistently treated these and all similar workers as independent contractors in the past; and (3) the company has consistently filed Form 1099-MISC information returns for these and all similar workers.
If after reviewing the 20 factors, one is still unsure whether the person being hired should be classified as an employee or an independent contractor, he can complete Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Tax and Income Tax Withholding. After reviewing the situation, the IRS will make the determination for you. One can also consult with a CPA.