Worker Classification Can Be Very Costly | Kaiser Tax

Worker Classification Can Be Very Costly

The number of independent contractors working in the United States has risen steadily over the last two decades. But did you know you can’t simply label a worker as an independent contractor? The facts and circumstances of the relationship determine if the worker is an employee or an independent contractor.

By hiring independent contractors, companies save time and money on payroll processing, avoid paying payroll taxes like FICA and unemployment taxes, and don’t need to purchase worker's compensation insurance or provide retirement and other benefits. 

But misclassifying an employee as an independent contractor can be very costly for a business. The company will owe back payroll taxes. Payroll taxes are a top priority for the tax agencies, and the fines and penalties are horrendous!

When do these issues come up? 

Typically, everything goes great until you stop paying the worker in question. The classic example is a company stops paying a worker, who goes down to their local unemployment office and files for benefits. There, they find out they're not eligible for benefits because they were self-employed. At that point, the worker will say that they were misclassified or treated incorrectly. This starts a series of problems for you as an employer.

How do I know if I’ve misclassified a worker?

Ultimately, a worker is an employee if he or she is subject to the will and control of the employer. It's not necessary for the employer to control or direct the work that's performed. It is sufficient if the employer has the right to do so.

The IRS, the state department of revenue, and the unemployment department all like W-2 employees. They can and will take issue with your worker classification. In revenue ruling 87-41, the IRS developed a 20-factor test to determine if an employee has been misclassified as an independent contractor. Kaiser Tax has represented many companies in worker classification audits.

Here are a few of the 20 factors that get businesses into trouble fast.

  1. The company pays or reimburses the independent contractor for expenses. You should never pay for an independent contractor’s expenses--NONE WHATSOEVER. To be truly an independent contractor, the worker must have the ability to lose money. If the worker doesn't have business expenses, they can't lose money, and therefore they are clearly your employee. Instead, simply pay the independent contractor more money and have them pay for their own expenses.
  2. The worker is paid hourly and on a regular schedule such as weekly, biweekly, or monthly.It is much better to pay independent contractors on a project basis. The independent contractor can submit a progressive billing based on completion of the project so they don't have to wait for the project to be complete to be paid. They could take payments after a project is 20%, 40% or 50% completed and take progressive payment. Or, you could pay a commission or flat fee. 
  3. Workers perform services mostly on your premises. Government agencies assume if the worker is performing services at your location and with your equipment, they are employees. Have the worker perform services outside your premises at least some of the time. 
  4. You have a long-term, continuous relationship with the worker. Consider putting together a series of contracts that each last 6 to 12 months. The period is short and you can always have another contract once the current one expires. This avoids the continuous relationship problem.
  5. You don’t allow workers to work outside your company. You don't want independent contractors working exclusively for your business. That points to an employee/employer relationship

How can I avoid misclassifying a worker?

Kaiser Tax recommends you work with a professional to design an independent contractor agreement. Always have the independent contractor agreement signed by both parties and follow the agreement. The independent contractor must complete a W-9 form. We suggest not paying a contractor until you have received a completed W-9 from them. Use getting paid as leverage to getting that form completed. 

Lastly, treat all similar workers in the same manner. They're all either employees or independent contractors. Do not have some of each. Issue independent contractors 1099s each year by January 31. It's always better to pay a business entity versus an individual. Consider having your independent contractors form an LLC and have a contract between your company and their LLC. 

A note for corporations

By federal statute, any person who owns 2% or more of a corporation is an employee. You cannot be an independent contractor for a company in which you have an ownership interest. This also applies to your spouse, kids, and parents. In other words, all family members are employees of a corporation you have an ownership interest in.

Many companies pay independent contractors to avoid paying benefits and payroll taxes. If your company does this, you must be very careful to design and follow an independent contractor agreement that can hold up under audit. The consequences of misclassifying a worker are huge. Remember an ounce of prevention is worth a pound of cure. For help with a worker misclassification audit or tips for hiring an independent contractor the right way, contact Kaiser Tax today. 




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