Independent Contractor or Employee?

This seems like such a simple question. However, many companies and employees never take the time to consider their position. This is one of the most important decisions in the tax world. In fact, it goes well beyond taxes as it involves workers’ compensation, unemployment insurance, state and federal wage and labor laws, pension laws, nondiscrimination laws and more.

From an employer’s perspective, it’s often preferable to hire freelancers and contractors instead of employees. An employer is not required to pay for all the benefits offered to regular employees, such as health insurance, bonuses, 401(k) plan contributions, and so on. As a result, employers experience considerable incentives when utilizing independent contractors. More often than not, such employment follows the regulations set forth by the law. Nevertheless, some employers have been accused of misclassifying workers who should be considered employees as contractors instead.

The IRS has issued guidelines on the matter, stating "if you have the right to control or direct not only what is to be done, but also how it is to be done, then your workers are most likely employees." Meanwhile, "If you can direct or control only the result of the work done -- and not the means and methods of accomplishing the result, then your workers are probably independent contractors." The distinction is important because there are penalties for misclassification.

For businesses of all sizes, the fines are everywhere and they’re not cheap. Take a look:

  • The Department of Labor ordered three construction companies to pay $491,100 in back wages and damages to 99 employees who were misclassified as independent contractors, in addition to another $108,900 in civil fines.
  • A prominent shipping company settled a series of class action lawsuits alleging worker misclassification for a total of $27 million. Previously, the IRS had already ordered the company to pay $319 million in back taxes and penalties.
  • The San Diego Union Tribune, owned by The Copley Press Inc., was ordered by a state court judge in California to pay $6.1 million in legal fees to the attorneys for a class of over 1,200 paper carriers to whom the court had earlier awarded $3.2 million in damages and another $1.75 million in interest. The final cost of the verdict against the newspaper for misclassification of the paper carriers as independent contractors totaled $11 million.
The IRS has given guidelines to its agents to determine worker status. In the past, a list of 20 factors compiled by the IRS had been used in court decisions to determine worker status. The list, sometimes called the “20-Factor Test” is still used as an analytical tool, although some of the factors are no longer as relevant as they once were.

Basically, the IRS’ 20-Point Checklist focuses on three main factors:

  • How much control the employer has over the worker’s behavior and work results. (Who controls training, where and what time the person works, what equipment they use?)
  • How much control the employer has over finances? (Does the employer have primary control over the person’s profit or loss?)
  • What is the relationship between the parties? (Does the worker receive benefits? Is it a long-term relationship?) Estimates are that 20% of businesses misclassify workers, so make sure your business understands the difference.
By: Mark Dietrich, Accountant

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