A recent article in The Wall Street Journal on March 14, 2013 entitled “Payroll Audits Put Small Employers of Edge” prompted us to remind you that misclassifying employees as independent contractors is risky and can be costly.iStock_000013564491 smaller

Many employers look at using independent contractors as a way to save money.  The employer is not responsible for paying the Social Security, Medicare, unemployment taxes and workers’ compensation insurance on independent contractors.  “Some employers also are turning to contractors to avoid hitting the 50-employee threshold that would require them to pay for employees’ health insurance, starting next year, under the federal health-care law, or pay a penalty.”

In addition, it eliminates paying other benefits such as paid time off and provides the flexibility of utilizing the worker only when there is sufficient work.  It can be seen as a great cost savings measure.  “A Michigan State University study estimates that contractors can save employers as much as 40% on labor costs.”

However, the IRS has cracked down on the misclassification of workers over the past three years.  Audits have increased dramatically because the IRS increased its budget for this purpose.  “Since September 2011, the government has collected $9.5 million in back wages for more than 11,400 workers who were misclassified as independent contractors by their employers, the Labor Department says.”

How do you know if you are correctly classifying a worker?

The classification guidelines are not black and white, which is the source of much confusion.  The determination is based on three Common Law Rules:

  1. Behavioral. Does the company control or have the right to control what the worker does and how the worker does his or her job?
  2.  Financial. Are the business aspects of the worker’s job controlled by the payer?  (This includes things like how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
  3. Type of Relationship. Are there written contracts or employee-type benefits (i.e., pension plan, insurance, vacation pay, etc.)?  Will the relationship continue and is the work performed a key aspect of the business?

You must weigh all these factors.  Unfortunately, there is no “magic” or set number of factors that “makes” the worker an employee or independent contractor.  Many times employers do not know that they have misclassified workers until they get audited.

Confused?

If you are still unclear as to the classification of a worker after considering the three Common Laws, the IRS has created Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) which can be filed by either the business or worker.  The IRS will review the facts and circumstances and then make an official determination of the worker’s status.

Because this is an area of much confusion, many employers do not want to run the risk of penalties from misclassification and choose to hire employees.  We encourage you to measure the workers you have classified as independent contractors against the guidelines.  If you discover that you have misclassified a worker, there is some good news.  In January, 2013 the IRS extended an amnesty program which waives or reduces some of the penalties of misclassification.

Don’t run the risk of IRS penalties.  Please contact us at 239-433-5554 if you would like additional guidance or have questions about the classification of workers.