Classification Warfare: Employee v. Independent Contractor - March 2015

Terry Jessop & Bitner Newsletter

Issue 19, March 2015

An important consideration for every business owner or manager is the proper classification of workers as employees or independent contractors. Make the wrong choice and it could cost you dearly. There are definite advantages to classifying workers as independent contractors instead of employees. Hiring a contractor rather than an employee saves the company payroll taxes, administration costs, workman's compensation, unemployment insurance, and benefits such as paid time off, health insurance, and retirement contributions. It also limits exposure for negligent acts of the worker. So why doesn't every employer do it? The answer is driven by tax law.

Improper Classification Can Be Costly

In short, the law puts some burden of collecting taxes on the employer rather than relying on the employee to remit his taxes. The theory is that an employer who is enriched by the labor of an employee should bear the administrative expenses associated with the employee's work. Independent contractors, on the other hand, are essentially self-employed and must bear their own tax burden. While there are good reasons to call a worker an independent contractor, those who may fudge a bit to save money should be warned: taxing agencies will exact a high price for any violation. If the IRS determines that an employee was improperly classified as a contractor, the employer may be audited and required to pay all back taxes, insurance premiums, or other costs and penalties for every employee wrongly classified, perhaps going back several years. The financial blow could be devastating.

Avoid Improper Classification

How do you avoid making this mistake? While agencies employ several tests, the most comprehensive test is used by the IRS. This test looks at factors related to behavioral control, financial control, and the nature of the employment relationship.

Behavioral control relates to the employer's ability to dictate how, when, and where the work gets done. Must the worker report at a specific place and time? Who provides the necessary tools or supplies and the workspace? How much does the employer control the details of the work? The more independent the worker is, the more likely he will be considered a contractor.

The IRS also examines financial control. Does the employer reimburse expenses incurred? How much does the worker invest in the project? Does he buy his own tools and supplies? Does the worker have other clients for whom he provides services? Is the worker paid with a one-time fee or periodically? The more financial risk a worker assumes, the more likely he will be considered a contractor.

Finally, the IRS looks at the relationship between the employer and the worker. Is there a written contract? Does the worker receive benefits? What is the length or permanency of the relationship? Is the work a key part of the business? Short relationships which relate tangentially to the core of the business likely denote an independent contractor rather than an employee.

None of the factors are determinative by themselves. All of the factors must be reviewed on a case-by-case basis. Often the distinction between employee and contractor is clear. But when there is a question we can walk you through the analysis and help you make the proper classification.

© Terry Jessop & Bitner March 2015