Independent Contractor vs. Employee: Is Your Business Classifying Workers Properly?

The “gig economy” has affected nearly every industry and profession. From Uber to Instacart, new business models have sprouted in recent years that build upon workforces treated as independent contractors. And even traditional businesses have been relying more heavily on freelancers and other contract workers, a trend that has accelerated during the COVID-19 pandemic.

From a business’s perspective, there are several tax and other advantages of classifying workers as independent contractors rather than employees. But it’s important to remember that workers aren’t independent contractors simply because you say they are or because you and the workers have written agreements to that effect. The IRS and other government agencies look at all the facts and circumstances to determine whether workers are misclassified.

What are the advantages?

For tax purposes, companies that properly treat workers as independent contractors avoid several tax obligations that apply to employees. For example, a company generally isn’t required to withhold federal or state income taxes, pay the employer’s share of Social Security and Medicare (FICA) taxes, withhold the workers’ share of FICA taxes, or pay federal or state unemployment taxes.

In addition, companies that use independent contractors may avoid several nontax obligations, including requirements to pay minimum wages and overtime under the federal Fair Labor Standards Act and similar state laws, furnish workers’ compensation insurance (in many states), make state disability insurance contributions, or provide employee benefits.

How is worker status determined?

To determine whether a worker is an employee or independent contractor, the IRS looks at several factors in three categories:

1. Behavioral control. Does the company control or have the right to control what the worker does and how the worker performs his or her job? Generally, the more control, the more likely a worker is an employee. Relevant factors include the extent to which the company provides instruction and training.

2. Financial control. Does the company control the business aspects of the worker’s job, such as how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies? Again, the more control, the more likely a worker is an employee. Relevant factors include:

  • The extent of a worker’s investment in items such as equipment and tools (a bigger investment tends to favor contractor status),
  • The extent to which the worker has unreimbursed business expenses (contractors tend to have a higher level of unreimbursed expenses),
  • A worker’s opportunity for profit or loss (the risk of incurring a loss generally indicates that a worker is a contractor),
  • Whether a worker makes services available to others (contractors are generally free to seek out other business opportunities in the relevant market), and
  • The method of payment (employees generally receive a guaranteed wage per hour, week or other time period; contractors are usually paid a flat fee — although some contractors are paid by the hour).

3. Relationship of the parties. Workers are more likely employees if the company provides them with employee benefits, such as health or disability insurance, pension plans, paid vacation, or sick days. The permanency of the relationship is also a significant factor: Employees are more likely to be hired indefinitely, while independent contractors are more likely to be engaged for a specific project or time period. Also, companies are more likely to use employees to provide services that are a key aspect of their business.

The terms of a contract that designates a worker as an independent contractor or employee aren’t controlling. However, they may be relevant in showing the parties’ intent to form a specific type of relationship.

IRS penalties for misclassification

The consequences of misclassifying employees as independent contractors can be severe. Among other things, the IRS may assess back taxes against the company (including employees’ shares of unpaid payroll and income taxes), plus penalties and interest.

Notably, the IRS can impose significant penalties on an employer, even if workers wrongly classified as independent contractors met all of their tax obligations. And don’t overlook nontax implications. For example, a company that misclassifies workers as independent contractors may be liable for unpaid benefits, minimum wages, overtime pay or workers’ compensation premiums.

Review your hiring policies

Given the significant cost of misclassifying workers, it’s a good idea for businesses to review the current status of their workforces and evaluate their hiring policies to ensure that they’re meeting all of their obligations under federal and state law. If you believe that you’ve misclassified workers, look into voluntary classification settlement programs that allow you to resolve these issues with the government at the lowest possible cost.

Watch out for conflicting standards

Even if you’re comfortable with your classification of workers for federal tax purposes, evaluate your compliance with federal wage and hour regulations as well as various state laws. These may apply different standards or look at different factors in determining a worker’s status. The U.S. Department of Labor, for example, in assessing worker status for Fair Labor Standards Act purposes, analyzes a set of factors that are similar but not identical to those used by the IRS. And several states have laws that make it more difficult for employers to treat workers as independent contractors.

To avoid a situation in which a worker is treated as an employee for some purposes and as an independent contractor for others, consider all applicable standards as part of the classification process.

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