Many companies use independent contractors to cut payroll taxes and the high cost of fringe benefits. But using outside workers can result in problems. It's no secret that the IRS scrutinizes relationships between businesses and independent contractors.
If independent contractors are legitimately independent, there's no problem. But if the IRS "reclassifies" them as employees, you can be slapped with hefty bills for back taxes, plus interest and penalties. And audits by state agencies are even more common than IRS audits and frequently occur when independent contractors apply for unemployment or Workers Compensation.
In determining whether an individual is an employee or an independent contractor, the IRS and courts examine the entire relationship.
According to the IRS, facts that provide evidence of the degree of control and independence fall into three categories:
Behavioral. Does the company control (or have the right to control) what the worker does and how the worker does his or her job?
Financial. Are the business aspects of the worker's job controlled by the business? (These include factors such as how the worker is paid, who provides tools and supplies and whether expenses are reimbursed.)
Type of Relationship. Are there written contracts or employee type benefits (such as a pension plan, insurance and vacation pay)? Will the relationship continue and is the work performed a key aspect of the business?
Here are some of the other factors the IRS and courts consider to determine if a worker is an employee or independent contractor:
Assistants. Employees don't hire and pay others to help them do their jobs (although they may be told to hire assistants for the company). In contrast, contractors often hire, supervise, and pay their own assistants.
Training. Employees are more likely to receive training from an organization than independent contractors.
Other Customers. Independent contractors generally make services available to the public and are able to work for two or more businesses.
Financial Risk. A worker's opportunity to personally earn a profit and assume risk of loss may indicate a non-employee status.
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other indicate independent contractor status. There is no "magic" or set number of factors that makes the worker an employee or an independent contractor, and no one factor stands alone in making this determination.
There are several steps a business can take to increase the chance that workers are properly classified as independent contractors.
Have written, signed contracts with workers classified as independent contractors, spelling out the terms and conditions of the relationship. Consult with your attorney in the preparation of contracts.
Have the contractor complete Form W-9, "Request for Taxpayer Identification and Certification." This form can is used to request the correct name and Taxpayer Identification Number of the contractor. The W-9 should be kept in your files for four years for future reference in case of any questions from the worker or the IRS.
Once contracts are in place, give outside workers leeway over how they perform their duties. Resist the urge to supervise them the way you oversee employees.
Send each contractor a Form 1099 showing non-employee income if you pay $600 or more in a calendar year. The annual deadline for sending these forms is January 31. Caution: Just because a worker enters into a written independent contractor agreement with your business, or you send out a 1099 form, doesn't mean the individual is deemed an independent contractor. Government agencies and courts look at the facts described above to determine the status of a worker.
Consistently treat workers performing similar tasks as either independent contractors or employees. Don't supply outside workers with services you give employees. Some companies run into trouble after they provide office space, computers, cars and other perks.
Maintain good records. Obviously, you need to keep an independent contractor's taxpayer ID number and other information required by the IRS on Form W-9, but you should also keep items that help prove the person is self-employed. For example, business cards, a letterhead, invoices and advertisements placed in newspapers. Keep copies of business licenses and print out contractors' website pages showing that services are offered to the public. You want to be able to convince an IRS auditor that an independent contractor is in business for him or herself.
Do a self-audit of each worker's or each class of workers' status before a federal or state agency conducts one. In addition, consider having your CPA or attorney conduct an audit of each worker's status.
Conclusion: Employers that misclassify workers as independent contractors can end up with substantial tax bills as well as penalties for failing to pay employment taxes. They may also face employee benefit liability. In some cases, workers sue for benefits they claim they were eligible for, including overtime, health insurance and retirement plan contributions.
