Employee or Independent Contractor? – Why It Matters
Friday, October 14, 2016
Many business owners like to treat individuals that perform services for them as independent contractors rather than employees. It relieves them from having to pay FICA, Medicare and state unemployment taxes as well as providing benefits such as workers compensation, health insurance and vacation pay. But if the IRS or state determines that an individual that was treated as an independent contractor is actually an employee, the payroll tax liabilities, interest and possible penalties will be painful.
What are the Consequences of a Reclassification?
If the IRS determines that a worker that has been treated as an independent contractor is an employee, the employer will be required to pay FICA, Medicare and Federal Unemployment taxes for the period during which the worker was so misclassified. Interest and possibly penalties may be assessed as well. In addition, since the employer is required to withhold Federal income taxes from the employee’s wages, the employer may be required to pay the income taxes that were supposed to be withheld unless he can document that the employee paid those taxes. This may require that the employer get copies of the worker’s tax returns. Good luck with that.
If a state determines that there has been a misclassification the employer will be required to pay state unemployment insurance on the wages as well as interest and penalties. This issue often comes up when a terminated worker who had been treated as an independent contractor applies for unemployment insurance.
How Does IRS Categorize a Worker as an Independent Contractor or Employee?
There is no definitive IRS test to determine whether a worker is an independent contractor or employee. Several aspects of the relationship between a business and a worker are considered including:
- What instructions the employer gives the worker about when, where and how the work is to be done. It is a matter of control. The more control exercised, the more likely the worker will be considered an employee.
- The level of training that the employer gives to the worker. Independent contractors generally don’t receive training from an employer.
- The extent to which the worker has business expenses that are not reimbursed. Independent contractors are more likely to incur unreimbursed expenses.
- The extent to which the worker invests in his own business such as tools, equipment and facilities.
- The extent to which the worker provides services to other businesses.
- How the business pays the worker. An employee is generally paid by the hour, week or month. An independent contractor is usually paid by the job.
- Can the worker make a profit or incur a loss? Independent contractors have a profit motive which an employee generally does not.
- Is there a written contract that defines the relationship between the business and worker that would create the independent contractor role?
- Does the business provide benefits that are generally only provided to employees such as medical insurance, a pension plan, vacation pay or overtime?
The Part-Time Worker
It is understandable that an employer would like to treat people that work for them on a part-time basis as independent contractors. They want to avoid the paperwork and payroll costs involved with someone that may work only a few hours a week. But the number of hours that a person works is not a factor in determining the employee vs. independent contractor status. Regardless of the number of hours that someone works, if they meet the characteristics of an employee they should be treated as an employee.
Avoid a Costly Misclassification
Treating an employee as an independent contractor can be costly. If there is uncertainty about the classification of an individual that works for you consult your accountant.