Employee or Independent Contractor?

Many businesses are relying on contract workers to get things done and reduce overhead expenses. But does your contractor qualify as an employee? Jennifer Lollino of Sickich LLP explains.

Businesses continue looking for ways to decrease costs while producing the same quality of work. Relying on independent contractors allows them to get the specific skills their organization needs, without the expense of payroll and benefits for regular, full-time employees.

At the same time, the IRS’ Employment Tax National Research Project is randomly selecting 6,000 businesses for worker classification audits. From 2010-2012, these audits will ensure that all of the appropriate withholdings and tax implications are being fulfilled. The misclassification of a worker’s status can lead to expensive tax liabilities and employer penalties.

What classifies a worker as an employee versus an independent contractor? Determining whether an individual is an employee or an independent contractor may be more complex than it first appears. This determination is based on evidence related to the degree of control and the independence of action that the alleged independent contractor exercises in completing his/her work.

Jennifer Lollino
The “common law” rules, developed by the courts and Section 530 of the Revenue Act of 1978, outline that a worker generally is an employee, for federal tax purposes, if the employer has the right to control and direct the worker regarding job functions and processes. The employer does not actually have to direct or control how the services are performed, but he/she has the right to do so.

On the other hand, an independent contractor retains control of how the work is completed, even though an employer may control the result of the work.

What are the factors that determine how much control a worker has? The IRS evaluates three broad categories to determine whether the individual is an independent contractor or an employee:

Behavioral Control: As the employer, how much control do you exercise over what the worker does and how the worker does his/her job?
Does the worker choose where and when to do his/her work?
Does the worker select/manage the tools, supplies or services used?
Does the worker select, train and set the schedules for his/her employees or assistants?
Does the worker determine the process or procedures needed to complete the work, getting only general direction from you?

Financial Control: As the employer, do you control the business aspects of the worker’s job?
Do you pay the worker based on invoices that he/she provides?
Do you pay overtime or reimburse expenses other than those outlined in the worker’s proposal/contract?

Type of Relationship
Do you have a written contract with the worker?
Do you specifically indicate that you do not provide benefits such as healthcare insurance, life insurance, vacation pay, etc.?
Is the work interim in nature and considered non-essential to the running of your organization?

Organizations often look to Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. This form provides additional information to help you make a more accurate determination as to whether the individual in question is an employee or an independent contractor. Please note that this form is designed to seek a determination from the IRS and it can take up to six months to receive a determination.

What if I have misclassified an employee as an independent contractor? You may qualify for relief under Section 530, provided you meet each of these requirements:

You had a reasonable basis for not treating the workers as employees. (For example, a “reasonable basis” exists if a significant segment of the employer’s industry has traditionally treated similar workers as independent contractors.)

You (and any predecessor business) have treated the workers, and any similar workers, as independent contractors. (If you treated similar workers as employees, this relief provision is not available.)
You have filed all required federal tax returns (including information returns) consistent with your treatment of each worker as not being an employee.

What can I do to protect myself against a worker classification audit? Some say the best defense is a good offense, and a solid paper trail is crucial if the time comes to prove your classification.

Documentation that can support the classification of your independent contractors includes agreements that clearly state the relationship as non-employee; well-kept payroll records, including every invoice from the contractor; separate, full-time employment agreements; and employee manuals that distinguish between workers. ❚

Jennifer Lollino is Vice President of Human Resource Consulting Services for Sikich LLP.