Determining Worker Status

Published:

According to the IRS, the misclassification of workers as independent contractors (rather than employees) accounts for billions in unpaid taxes each year. As a result, the agency has been zeroing in on misclassification as a revenue raiser. And, since it’s found that it’s more difficult to collect from independent contractors, it tends to favor employee status. This article discusses some of the most important factors the IRS uses in making the determination, and what employers can do if they’re unsure of their compliance.

Worker status: What you decide may cost you

If you’re like many businesses you’ve started engaging more independent contractors over the last few years to handle some of the workload. But there’s a hitch: According to the IRS, the misclassification of workers as independent contractors (rather than employees) accounts for billions in unpaid taxes each year. This sum could help reduce the escalating national deficit, among other things, so the agency has been zeroing in on misclassification as a revenue raiser.

What’s the big deal?

If a worker is an employee, your business must provide a Form W-2 annually and:

  • Withhold income tax and the employee’s portion of Social Security and Medicare taxes from the employee’s pay, and
  • Pay the employer portion of Social Security, Medicare and unemployment taxes on the employee’s wages.

If a worker is an independent contractor, your business generally should provide a Form 1099-MISC, which reports the amount you’ve paid to the person that year. The independent contractor is responsible for paying employment taxes (both the employee and employer portions) and income taxes on his or her own.

While the IRS generally should receive the same amount of total income and employment taxes regardless of whether someone is an employee or an independent contractor, it has found that it’s more difficult to collect from independent contractors. Thus, the agency tends to favor employee status.

How do you know?

To determine whether a worker is an employee or an independent contractor, you must consider your business’s degree of control and the person’s level of independence. The IRS has assembled a number of questions to help employers decide. Commonly referred to as the “20-factor test,” the questions revolve around:

  1. Behavioral control — whether your business has the right to control the individual and how that person performs his or her duties,
  2. Financial control — which aspects of the worker relationship your business controls, and
  3. Type of relationship — whether there’s a written contract between the individual and your business, and if the person receives employee benefits.

Here are a few of the most applicable IRS factors, and what a business’s responses might indicate:

Instructions. Workers who are required to comply with someone else’s instructions on when, where and how they complete the work are typically employees.

Training. A business typically trains its employees on the “how-tos” of the job, but independent contractors are expected to already know how to do the job. So, if training is provided to the workers, this could indicate that they’re employees.

Hiring, supervising and paying assistants. Independent contractors must pay their assistants. If the business is supervising and paying a worker’s assistants, the worker typically is an employee.

Setting work hours. If a worker has the ability to set his or her own daily hours (within reason), that person typically is an independent contractor.

Other factors in the IRS “test” include whether the person works for more than one business at a time and is paid by the hour, week or month (vs. by the job).

What else can you do?

If you’re still unsure whether an individual should be classified as an employee or an independent contractor, you can complete Form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding,” and the IRS will decide for you. The process is free, and it typically takes six months or more to receive the determination.

If your business receives a Form SS-8, it’s imperative to fill it out and return it by the due date. Failure to respond to the IRS’s request won’t prevent a determination, even though your business’s input could have been crucial to the outcome.

Keep in mind that, if the IRS deems that a misclassification has occurred, your business could be held liable for all of the misclassified person’s employment taxes — plus interest and penalties. And if the agency finds willful negligence (the business knowingly misclassified the worker), the IRS can assess penalties of 20% of all wages paid to the worker as well as 100% of the FICA/Medicare that should have been withheld on that individual’s paycheck.

Be certain

If your business uses independent contractors, evaluate these relationships to determine whether the status for each individual is correct. Even if you’ve used an independent contractor for a few years, re-evaluate that person. Make sure that his or her circumstances haven’t changed in a way that might jeopardize the independent contractor status.

Sidebar: Write it down

Keeping good records on your employees and independent contractors is imperative, not only because of the potential for an audit, but also in case one of your workers challenges his or her status as an independent contractor. In either scenario, you’ll already have all of the facts on hand to respond to IRS questions.

Document the facts and circumstances surrounding each decision to classify a worker as an independent contractor and not an employee. You can refer to the IRS’s 20-factor test in the following pages. Also consider keeping files on independent contractors just as you do your employee files for support in case the IRS sends you a blank Form SS-8 or your business is pulled for an IRS audit. Include any contracts and invoices in the contractor’s file.

If you would like additional information or to discuss the topics mentioned, please contact Jim Wagoner, CPA at 317-260-4472 or jwagoner@greenwaltcpas.com.