Does your business hire independent contractors?  If so, have you considered the pros and cons of treating these contractors as employees?  The IRS has announced that it will conduct 6,000 examinations over the next 3-years on random employment issues, specifically targeting misclassified workers that are claimed as independent contractors.

You might be surprised to find out that the relationship is much more likely to be that of employer/employee and that this misclassification can also be much more expensive than you might think!  Since the penalties for incorrectly treating an employee as an independent contractor can be severe, you may want to reconsider the status of your workers.

It is common for small businesses owners to make the mistake of misclassifying the type of workers that they use.  Some do so simply because they don’t fully understand the rules surrounding this classification, while others believe it to be a cost savings strategy.  What small business owners don’t always realize is that they probably aren’t really saving anything and that their exposure in the long run could be much more than any of these so-called savings.

An company’s tax liability is determined by the worker’s employment status. When a worker is an employee, employers must pay state and federal unemployment tax, social security tax and workers compensation/disability premiums to a State Insurance Fund. When a worker is an independent contractor, the hiring party is not required to make any of these payments.  Some small business owners might try to hire workers and incorrectly label them as independent contractors in order to avoid these tax and insurance liabilities.  Companies might even pay these independent contractors a higher rate and advise them that they are responsible for paying and remitting their own payroll and employment taxes and carrying their own insurance.  When this is the case, the bottom line is that hiring an independent contractor should not cost more (on an hourly basis) than hiring someone as an employee.

Generally, an individual who performs services for you is your employee if you have the right to control what will be done and how it will be done even when you give the individual freedom of action.  What matters is that you have the right to control the details of how the services are performed.  On the other hand, an individual is generally an independent contractor if the person for whom the services are performed has the right to control or direct only the result of the work and not the means and methods of accomplishing the result.

In determining whether the person providing service is an employee or independent contractor, all information that provides evidence of the degree of control and independence must be considered.  Facts that provide evidence of the degree of control and independence fall into the following three categories:

1. Behavioral control: The more control you have over the work performed, the more likely your workers are employees. Behavioral control includes the right to tell a worker how, when, and where to do the work, even if you don’t exercise that right.
2. Financial control: Do you pay for tools, equipment, facilities, and business and travel expenses? That can indicate an employer/employee relationship. Independent contractors typically take on a certain amount of financial risk themselves.
3. Type of relationship: Independent contractors usually provide the same or similar services to others and receive no employee-type benefits from you, such as paid vacation or sick days.

These categories are based on a list of factors the IRS uses as guidelines, but the final decision requires an objective facts-and-circumstances analysis of each situation.  If an employer/employee relationship exists, it does not matter what it is called or how it is labeled.  The employee may be called an agent or independent contractor, but it is the substance of the relationship, not the label, that governs the worker’s status.  It also does not matter how payments are measured or paid, what they are called or if the employee works full or part time.

If you classify an employee as an independent contractor with no reasonable basis for doing so, you may be held liable for employment taxes for that worker.  You will generally be liable for social security and Medicare taxes and withheld income tax if you did not deduct and withhold these taxes because you treated an employee as a nonemployee.  You will not be able to recover the employee’s share of social security, Medicare or income tax withholding and very well may also be liable for the income taxes regardless of whether or not the employee paid income taxes on the wages.

In addition, if the worker should get hurt while working for you, you can be sure that your worker’s compensation insurance will be challenged and that if you should have insured the worker (but didn’t because you misclassified his status) then you may very well be liable for any medical claims as a result of the injury.  The same could also be said for state unemployment, if the worker involuntarily stops working for you and files a claim.