Many small businesses incorrectly classify employees as independent contractors. This mistake can cost your business money in back wages and penalties. There are several factors the federal government uses to determine whether someone is an independent contractor or an employee. We will look at those factors in detail and offer some suggestions to avoid the tax problems of misclassifying employees as contractors.
An independent contractor is an individual that works for themselves. They are not employed by another entity and have more independence than an employee would. They have control over all aspects of the job, from what they do to how they do it. Independent contractors typically provide their own equipment and supplies, as well as set their own hours. Independent contractors are often hired to work on an hourly basis but can also be paid one flat rate for a job.
An employee is typically a worker who has a contract with an employer and receives a set wage or salary and may receive benefits. The employee must conduct their work in the location determined by the employer. The employer typically provides the employee with a work uniform, equipment, and supplies. A key factor in whether an independent contractor relationship exists is the right to control the manner and means of performance. The more control an employer has over the worker, the more likely that worker is an employee.
IRS 20-Factor Test
The IRS uses twenty factors to determine whether someone is an independent contractor or an employee. No single factor controls the determination of the worker’s status. Let's look at each factor and see how they might apply to your business.
Instructions. Is the worker required to comply with the employer’s instructions about when, where, and how to work?
Training. Is training required? Does the worker receive training from or at the direction of the employer, including attending meetings and working with experienced employees?
Integration. Are the worker’s services integrated with the activities of the company? Does the success of the employer’s business significantly depend upon the performance of services provided by the worker?
Services Rendered Personally. Is the worker required to perform the work personally? Can they subcontract out the work to be performed?
Authority to hire, supervise, and pay assistants. Does the worker have the ability to hire, supervise, and pay assistants for the employer?
Continuing Relationship. Does the worker have a continuing relationship with the employer?
Set Hours of Work. Is the worker required to follow set hours of work?
Full-time Work Required. Does the worker work full-time for the employer?
Place of Work. Does the worker perform work on the employer’s premises and use the company’s office equipment?
Sequence of Work. Does the worker perform work in a sequence prescribed by the employer? Does the worker follow a set schedule?
Reporting Obligations. Does the worker submit regular written or oral reports to the employer?
Method of Payment. How does the worker receive payments? Are there payments of regular amounts at set intervals?
Payment of Business and Travel Expenses. Does the worker receive payments to reimburse them for business and travel expenses?
Furnishing of Tools and Materials. Does the worker rely on the employer for tools and materials?
Investment. Has the worker invested in the facilities or equipment used to perform the services?
Risk of Loss. Is the payment made to the worker on a fixed basis regardless of the profitability or loss of the business?
Working for More Than One Company at a Time. Does the worker only work for one employer at a time?
Availability of Services to the General Public. Are the services offered to the employer unavailable to the general public?
Right to Discharge. Can the worker be fired by the employer?
Right to Quit. Can the worker quit work at any time without liability?
If you answered many of these questions with “yes,” you most likely have an employer-employee relationship. If most of your answers are “no,” you could have an independent contractor relationship.
You cannot contract away a worker’s status as an employee. Just because you say someone is an independent contractor, or even have a signed contract that says they are an independent contractor, does not mean those workers are independent contractors for IRS purposes. The 20-factor duties test listed above overrides any contract you may have with an employee.
The Dangers of Misclassifying Employees as Independent Contractors
Some employers intentionally misclassify employees as independent contractors to avoid paying minimum wage, overtime compensation, worker’s compensation, and other obligations to workers. Employers do not withhold federal, state, and local taxes from wages paid to independent contractors. They are not included in an employer’s benefits programs and are exempt from wage and hour and employment discrimination laws, and unemployment insurance. In the short run, these are savings to the employer.
Even though the immediate costs of having an employee can be costlier than paying them as independent contractors; the long-term costs, if the IRS finds out you misclassified an employee as an independent contractor, will be much more. Penalties can include back taxes or premiums, civil fines, interest, other retroactive damages, and even attorney’s fees to defend you against government agencies or civil lawsuits.
If you are paying workers as independent contractors who should be paid as employees, I encourage you to “hire” them legally and properly. It is a business risk to continue paying them as independent contractors and as a business owner, you should attempt to limit as many risks as you have under your control.
We can help you determine if you are properly classifying your independent contractors or draft an Independent Contractor Agreement for you. Learn more about our business services here.