Independent Contractor vs. Employee: Be Sure to Get it Correct

Classification of workers as either independent contractors or employees has become a bitter issue. One reason is due to the recent growth of companies like Uber and Handy, which rely on systems of workers the companies say are independent contractors.

Both the U.S. Department of Labor (“DOL”) and the IRS, along with a number of states, are paying more attention to this issue. In recently issued guidelines, the DOL stated, “The misclassification of employees as independent contractors is found in an increasing number of workplaces in the United States.”

Different Tax Treatments

Why do businesses choose to classify workers as independent contractors? One of the main reasons is to reduce their tax obligations. An employer is required to pay the employer portion of FICA taxes for all employees, but not for independent contractors. Also, an employer is required to withhold income taxes from employee wages, but isn’t required to withhold them from payments to independent contractors.

While there are many other obligations associated with employees that make independent contractors appealing to businesses, these two tax obligations elicit the greatest amount of attention from both federal and state tax authorities.

Five Factors

Recent guidelines state that there is no single factor that typically determines whether a worker should be classified as an employee or independent contractor. Instead, the decision hangs on an “economic realities” test that attempts to differentiate workers who are economically dependent on an employer — and are therefore employees — from those who are in business for themselves.

Fortunately, the DOL and IRS have determined five factors that can assist employers in determining a worker’s status:

  1. The extent to which the work performed by the worker is an integral part of the employer’s business. The more integral the work performed, it’s more likely that the worker is economically dependent on the employer, and is an employee. Moreover, the work can be considered integral, even if it’s just one step in the process, performed by multiple individuals and/or performed away from the employer’s place of business. For example, most carpenters perform work which is integral to a construction company, even though they typically work outside of the headquarters office.
  2. The worker’s opportunity for profit or loss, depending on their managerial skill. The crucial word here is “managerial.” Just because a worker is technically proficient at a task — say, installing and repairing cable services — doesn’t mean they are running their own business. Similarly, a worker’s ability to earn more money by taking on extra work from the employer typically doesn’t signal an independent contractor relationship.

Rather, an independent contractor shows managerial skill by, for example, deciding whether to hire employees or purchase equipment, and also marketing their business. A worker in business for themself also faces the possibility of a financial loss, such as if what they charge for services doesn’t cover costs.

  1. The extent of the relative investment by both the employer and worker. A truly independent business owner will invest in their company, and the investment will go beyond simply purchasing the tools needed to do the immediate job. The DOL has provided this example: A cleaning person who uses their own cleaning supplies, while the employer provides a vehicle and insurance, and covers the cost of marketing the business, likely isn’t an independent contractor.

 

  1. Whether the relationship between the worker and employer is permanent or indefinite. When the relationship is permanent or indefinite — as is the case with many at-will employees — rather than project- or contract-based, the worker is more likely to be an employee.

 

  1. The nature and degree of the employer’s control. A truly independent contractor will exert control over a meaningful part of the work and relationship with the employer. For example, they typically will control the way the work is completed. Moreover, few companies can escape this provision by stating that client demands or regulations require them to exert control over their workers.

Consequences of Misclassification

Employers that misclassify workers as independent contractors, rather than employees, may have to pay back taxes, interest and penalties, along with other costs. Undoubtedly, the consequences of misclassifying workers can be severe. So make sure you consult with your tax professional. He or she can help you accurately determine whether your workers are independent contractors or employees.

© 2015

 

 

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