Business owners often lack clarity on when to classify a worker as an employee and when to classify a worker as an independent contractor. Classification of a worker as an independent contractor may initially save the business money and benefits such as group health and retirement benefits, workers’ compensation coverage, as well as Social Security and unemployment insurance taxes. In most cases, the only tax form employers have to complete for an independent contractor is a Form 1099-MISC.
Classifying workers as employees, on the other hand, requires that the business undertake several tax-related actions. This includes: withholding federal, state, and local income taxes; paying half of the Social Security and Medicare Taxes; paying the full tax required under the Federal Unemployment Tax Act and any amount required under State unemployment insurance tax laws; paying for workers’ compensation; filing a number of returns during the course of the year with the various tax authorities; and providing Form W-2s by January 31. The employee may also have rights to any employee benefits offered, such as health insurance, paid vacations and holidays, and retirement plans. In addition, the employee is eligible for any Federal or State mandated entitlements, such as family medical leaves of absence, etc.
Despite the savings a business may accrue by classifying a worker as an independent contractor, it is critical to ensure that workers are classified correctly. Misclassification can result in significant liability down the road.
EMPLOYEE OR INDEPENDENT CONTRACTOR?
The IRS has issued guidelines to help businesses determine worker status. In the past, a list of 20 factors compiled by the IRS had been used as guidance to determine whether workers are employees or independent contractors. The IRS has now focused the analysis in three areas: 1) behavioral control; 2) financial control; and 3) the type of relationship between the individual and the business.
If the business has significant control over the individual’s work, that fact weighs in favor of classification of the worker as an employee. Facts that show whether the business has a right to direct and control how the worker does the tasks for which the worker is hired include the type and degree of the following:
- Instructions the business gives the worker; and
- Training the business gives the worker.
Much like behavioral control, if the business has significant financial control over the individual’s work, this also weighs in favor of classification as an employee. Facts that show whether the business has a right to control the business aspects of the worker’s job include, but are not limited to the following:
- The extent to which the worker has unreimbursed business expenses (independent contractors are more likely to have unreimbursed expenses than employees); and
- The extent of the worker’s investment (an independent contractor often has an investment in the equipment he or she uses in performing services).
Type of Relationship
The nature of the relationship between the worker and the business can also point toward the classification of a worker as an employee or independent contractor. Factors that determine the type of relationship between the parties include, but are not limited to:
• Written contracts describing the relationship the parties intend to create; and
• Whether the business provides the worker with employee-type benefits, such as insurance, a retirement plan, vacation pay, or sick pay.
Assumptions to Avoid in Classifying Workers
A business should not assume it is safe to classify a worker as an independent contractor simply because:
- The business owner thinks it is a free and open choice.
- The worker wants or asks to be treated as an independent contractor.
- The worker signs a contract that states they are an independent contractor.
- The worker does assignments sporadically, inconsistently, or is on call.
- The worker is paid commission only.
- The worker does assignments for more than one company.
Risks When Individuals are Misclassified
The stakes for failing to classify workers as employees are high.
For Federal income tax purposes, if the misclassification as independent contractor was intentional, severe Federal tax penalties result. If the classification was unintentional, the Federal tax penalties are less severe, but still significant.
The Federal tax penalty for failure to withhold Federal income tax from a worker’s paycheck is 100% of the amount of the unwithheld tax. In addition, interest is charged on the unpaid amounts. Likewise, the individual responsible for the misclassification within in the business is personally liable for the employer portion of the Social Security. Business owners are also generally personally liable for any unwithheld Michigan income tax.
In addition to the tax penalties and personal liability, misclassifying individuals as independent contractors can result in liability for failure to provide health and retirement benefits to the individuals. Failing to provide Federal and State mandated entitlements to family medical leave, COBRA, etc. can also lead to significant liability on the part of the business.
Another very substantial liability that can result from failing to properly classify individuals as employees is for worker’s compensation. Michigan law provides that if someone should have been covered by worker’s compensation and was not, and the person suffers a work related injury or illness, the employer becomes the worker’s compensation carrier and must pay the scheduled benefits directly. This can well exceed $100,000 per instance, depending on the injury or illness.
PLAYING IT SAFE
When in doubt about how to classify a worker, the most conservative approach would be to classify him or her as an employee. It is always advisable to seek professional advice from your attorney when these issues arise. As a matter of law, the business has the burden of proving a worker is an independent contractor. It is also important to note that when a former worker files an unemployment insurance claim, an investigation is automatically triggered by the IRS to determine the status of the worker.
The IRS uses the above guidelines to determine proper classification. It will also look to a written contract for independent contractor classification. Any such contract would generally set forth the terms of the relationship between the employer and the individual, and may include:
- A statement that the independent contractor is not entitled to employee benefits programs;
- A joint severability clause stating that if part of the contract is struck down, the rest of it survives; and
- Acknowledgment that the independent contractor is free to work elsewhere at any time.
A contract between the employer and the worker may be immaterial, however, depending on the facts and circumstances of the relationship between the employer and the individual.
If you are currently engaging independent contractors and are unsure if they are classified correctly, contact us for assistance in sorting through the issues. The IRS has a partial amnesty program for businesses that voluntarily disclose classification issues.