Fernway DiarySM

Aug 09, 2021

When a company hires a worker, the worker is either classified as an employee or an independent contractor. The implications of this may have a significant impact on business operations, and incorrectly classifying workers can lead to penalties imposed by federal and state governments.

Differences Between Employees vs. Contractors

The distinction between employees and contractors is primarily a legal one, but it impacts how a business pays its workers and whether it withholds payroll taxes and provides other benefits.

Employees

When a business hires an employee, the company generally controls when and how the employee works. For example, the employee may be required to follow certain procedures, work certain hours, and use preferred tools and equipment. Employers can also impose moonlighting policies to prohibit employees from working other jobs that interfere with their work or create a conflict of interest.

Companies can pay employees a salary or an hourly wage. Either way, the employer is required to withhold federal and state income and payroll taxes, pay federal and state unemployment taxes, and provide workers’ compensation coverage for employees.

Contractors

Businesses have less control over independent contractors than they have over employees. The company can assign duties, deadlines, and expectations for the contractor’s work product. However, it cannot control when or how the work is done. Independent contractors generally set their own hours, provide their own tools and equipment, and are free to work for others.

Companies can pay independent contractors by the hour or a flat fee for services rendered. The business does not have to withhold and remit payroll taxes unless payments are subject to backup withholding.

Employee vs. Contractor: Internal Revenue Services (“IRS”) and Department of Labor (“DOL”) Tests

Companies may prefer hiring independent contractors because they do not need to withhold and remit payroll taxes, pay for workers’ compensation and unemployment insurance, or provide other employee benefits. Independent contractors also qualify for fewer protections under US labor law.

The IRS focuses on three broad categories to determine the degree of control a company has over workers and whether they are employees or contractors.

1. Behavioral control – The worker is an employee if the company can direct and control the work they perform. Examples of behavioral control include providing detailed instructions on how, when, and where to work.
2. Financial control – The worker is an employee if the business has the right to control the financial and business aspect of the job. Examples of financial control include purchasing equipment for the employee to use and reimbursing work-related expenses.
3. Type of relationship – IRS guidelines also consider how the worker and business perceive their relationship. Contractors typically have a written contract stating that the worker is an independent contractor. However, the existence of a written contract is not sufficient on its own. Other relationship factors include whether the company provides benefits, whether the contractor has an ongoing relationship with the business or was hired for a specific project, and whether the worker provides services that are a key business activity.

The DOL applies the following “economic realities” test to determine if a worker is an employee or an independent contractor.

• The degree to which tasks performed by the worker are essential to business operations
• The permanency of the relationship between the worker and business
• The amount the worker has invested of their own equipment, materials, and supplies
• The nature and degree of control the employer has over the worker
• The contractor’s opportunities for profit and loss
• The level of skill, judgment, and initiative required for the worker to be successful

Consequences of Misclassifying Workers

Worker misclassification may come to the attention of federal and state governments in several ways. First, workers who believe they have been misclassified as independent contractors can file a complaint with the DOL or applicable state agency. Misclassified workers may file for unemployment benefits or submit workers’ compensation claims. State and federal agencies, including the IRS, regularly audit employers suspected of underreporting payroll taxes.

The DOL normally handles cases where there is a possibility that the business misclassified workers and substantially underpaid payroll taxes, unemployment contributions, and workers compensation premiums. A DOL investigation can include all employees and contractors hired by the business during a three-year period.

If the state or federal government determines that the business has misclassified employees as contractors, applicable penalties can be severe. The severity level depends on whether the investigation determines the misclassification was unintentional, intentional, or fraudulent.

For unintentional misclassifications, the employer faces penalties based on the fact that the payments made to independent contractors should have been classified as wages.

For intentional misclassifications or fraud, the IRS can impose a penalty of 20{d61ad4666dda706b731686a225909392f074403d16c1288901cab8f2cf34ab1f} on wages paid, plus 100{d61ad4666dda706b731686a225909392f074403d16c1288901cab8f2cf34ab1f} of the employee and employer’s share of FICA taxes and additional criminal penalties.

Conclusion

Misclassifying employees is a serious issue. If you are unsure how to classify a worker, we recommend seeking professional advice. In complex cases, it may be worthwhile to seek formal determination from the IRS as well. Also, it is crucial to maintain accurate and complete records on employees and independent contractors in the event of an IRS audit, DOL investigation, or worker challenge as to their status as an independent contractor.

For more information, please contact your US tax advisory team at youradvisor@fernwaysolutions.com or visit us at www.fernwaysolutions.com.

Disclaimer:
The above content is intended to support the marketing of professional services and should not be construed as written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular tax situation. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Fernway Solutions assumes no obligation to inform the reader of any such changes.