Employees Vs. Independent Contractors: How Should You Classify?
Have you stopped to ask yourself if you are filing the wrong tax form for your employees? Form W-2’s for each employee are due on January 31, 2017. However, a common mistake made by business owners is classifying a worker as an independent contractor when the duties performed by that worker indicate they are really an employee.
Misclassified workers are a common mistake made by business owners everywhere, and a 2012 study by the National Employment Law Project proved it. In just the states of Illinois, Massachusetts, New York, Ohio, and Pennsylvania, it was found that there were more than 2.03 million misclassified workers combined. The Department of Labor also commissioned a study that found 30% of audited firms had employees misclassified as independent contractors.
In terms of federal revenue, the U.S. Government Accountability Office estimated in 2006 that $2.72 billion was lost due to worker misclassification. Due to these circumstances, IRS is especially strict in enforcing worker classification. This means knowing the difference between an independent contractor and an employee is vital to every business owner.
Internal Revenue Code states that one is an independent contractor “if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.” Hiring employees requires you to pay payroll tax for employees’ wages. Some businesses classify all their workers as contractors which allows them to avoid payroll taxes altogether, posing a serious red flag for IRS.
Additionally, many employers make the mistake of not filing a W-2 for a worker who is really an employee and not an independent contractor. IRS or California EDD regularly reviews 1099s to determine if a worker is truly an employee and not an independent contractor.
Filing a 1099 on January 31 instead of a W-2 for a worker that you later determine should be an employee is problematic. Correcting this error after the January 31 deadline will require you to file an amended 1096 and 1099 for each worker and then amend your W3 (summary of all W2s the company issued in 2016) and file W-2s to each incorrectly classified worker.
Neglecting to file or incorrectly filing a W-2 can also get expensive. The late filing penalty is $30 per W-2, and IRS can assess up to a $500 fine on your business. The safe route in this scenario is to avoid classifying a worker as a contractor unless you can prove the work performed satisfies IRS’ 20-factor test.
Analyze these points in relation to the work they perform and the relationship or interaction with that worker:
- Workers who are required to comply with other persons’ instructions about when, where, and how he or she is to work is ordinarily an employee.
- Requiring another employee to assist a worker during the training period indicates that the employer wants the work done a specific way, meaning that worker is performing the duties of an employee.
- An employer shows direction and control when the worker’s services are integrated into business operations, meaning that the worker cannot be assumed to be a contractor.
- Employers cannot show preference in the methods used to accomplish the work done for them, especially when services are rendered personally.
- A person for whom the services are performed cannot hire, supervise, or pay other assistants to help with the work as this generally shows control over the workers, disqualifying them from contractor status.
- A continuing relationship between a worker and the person for whom the services were performed indicates an employer-employee relationship.
- The establishment of a set hours of work may indicate control over a worker and an employee-oriented relationship.
- A worker being forced to devote almost full time to a business indicates that the person for whom the services are being performed has control over the worker. Contractors should be able to be free to work when and for whom they choose based on their own schedule.
- Control over the place of work is indicated when the person or persons for whom the services are performed have the right to compel the worker to travel to a certain location to perform these services.
- Contractors must be able to perform services in an order or sequence set themselves. Any interference in this process by an employer show control over the worker and employee-type relationship.
- If a worker is required to submit a written or oral report on his or her services, this indicates a degree of control over the worker and an employee-type relationship.
- Payment to a worker on any basis other than by project or contract may indicate an employer-employee relationship.
- If the person for whom the services are performed pays for the worker’s travelling and/or business expenses, that worker is ordinarily classified as an employee.
- Contractors will generally provide their own tools, materials, and other equipment which help to perform their specific services.
- A worker depending on the person for whom the services are performed to provide sufficient facilities to perform said work generally indicates a form of control over the worker and an employee relationship.
- Workers who can either earn a profit or suffer a financial loss as a result of their services are generally classified as independent contractors.
- A worker performing services for multiple unrelated businesses at a time is generally classified as an independent contractor.
- Contractors make their work available to the general public on a regular and consistent basis.
- If an employer has the right to discharge a worker, this indicates an employee-employer relationship. Contractors, on the other hand, cannot be fired so long as their work meets contract specifications.
- Employees, not contractors, reserve the right to terminate their services to an employer at any time without incurring any form of liability.
It is important to understand the differences between employees and independent contractors to ensure your business is in compliance and to minimize the risk of an audit and an assessment of payroll taxes, penalties, and interest for the past three years. For example, a business owner who inadvertently misclassifies a worker as an independent contractor also fails to pay payroll taxes due.
Luckily, this is an easy problem to spot and even easier to fix. Each time you consider hiring an independent contractor, consider the IRS 20-factor test to determine if their work is actually oriented more toward an employee by focusing on the amount of control in the work relationship. Make sure you review IRS’ 20-factor examination and confirm all your workers are properly categorized as employees and not independent contractors prior to the January 31 deadline for W-2 forms.
Correcting the problem before the deadline can save you from being assessed additional taxes, penalties, and interest. If you correct the misclassified employees after the W-2 filing deadline, you will then have to file amended 1099s and a 1096 to remove the payments to these workers. You will also have to file late W-2s and an amended W-3. These late tax filings may trigger a payroll tax audit by IRS and state tax boards.
The information contained in this article is only intended for information purposes and is not intended to be legal advice. Should you have an EDD or IRS audit, or a legal question, please contact Milikowsky Tax Law at (858) 450-1040.