Contractor or Employee? Clearing Up Classification Confusion
If you're an employer, you know there are a lot of details to address in running your business. One of the biggest details to get right is employee classification. In other words, the designation between whether the people you hire to work with you are employees or independent contractors. The IRS regulations on classifying workers are complex and can be confusing. Many business owners work with a tax attorney to avoid common pitfalls.
The main issue with misclassification is that your business has tax obligations for employees and not for independent contractors. However, you can't arbitrarily determine how you designate your workers. There's a specific set of rules you'll need to follow to make that determination to ensure everyone in the equation is treated fairly. Here's what to know about common employment tax classification errors, IRS guidelines, and what to do if you need legal tax defense in this area.
Common Misconceptions and Errors in Classification
Unfortunately, there are many misconceptions that can lead to errors in classification. Understanding how those errors happen and the right ways to avoid them can help your business avoid penalties, such as fines and disrupted operations.
Control Over Work
Misconception: If a worker has significant control over how they perform their work, they must be an independent contractor.
Error: It's incorrect to assume that just because a worker sets their own hours or works off-site, they qualify as an independent contractor. Other important factors, such as their ongoing relationship with and dependency on your business, must also be considered.
Provision of Tools and Equipment
Misconception: Providing tools, materials, or other significant equipment to a worker is acceptable for independent contractors.
Error: This overlooks that supplying the necessary tools and resources for completing the job often suggests an employee status rather than that of an independent contractor.
Financial Risk and Opportunity for Profit or Loss
Misconception: A worker who is paid a flat fee for a job, rather than an hourly wage, is automatically an independent contractor.
Error: It’s important to recognize that true independent contractors have the opportunity to realize a profit or face a loss, which influences their approach to the work. Employees, by contrast, typically do not bear financial risks.
Method of Payment
Misconception: Paying workers on a project-by-project basis means they're independent contractors.
Error: Regular payments, even if made at intervals, might more closely resemble an employment relationship if other factors (like work conditions and employer control) align more with employee characteristics.
Exclusivity
Misconception: Workers who only provide services to one company are still independent contractors.
Error: It’s a mistake not to consider that independent contractors typically market their services to the public and work for multiple clients.
Duration of Relationship
Misconception: Short-term engagements are not indicative of an employment relationship.
Error: Incorrectly assuming that temporary or seasonal workers are independent contractors without considering other aspects of the relationship, such as the repetitiveness of the job and the nature of work, can be misleading.
Integration of Services
Misconception: If a worker’s role does not seem central to the business’s core operations, they can be classified as an independent contractor.
Error: One should not fail to evaluate whether the services provided are integral to the business’s operations, which would typically indicate an employee relationship.
IRS Guidelines and Criteria
The IRS has a specific set of criteria to determine whether a worker is an independent contractor or an employee. These are called the common law rules. The three main categories are Behavioral Control, Financial Control, and the Type of Relationship.
Behavioral Control involves whether your company has the right to dictate how and when the worker performs the job's duties.
Financial Control involves whether your business has control over how the worker is paid, who provides supplies, and whether there's reimbursement for expenses.
Type of Relationship involves aspects such as contracts, vacation pay, insurance, and other benefits, and whether the work is a key aspect of the business' operations.
If, after reviewing all three of these categories, you're still not sure which designation your worker should have, you can file IRS Form SS-8, which specifically requests the IRS to decide on a worker’s status for federal income tax purposes. It can take up to six months for the IRS to make a determination, and you may want to file this form if you frequently hire workers to perform specific tasks.
Legal Consequences of Misclassification
If you incorrectly classify your workers, you could face financial and legal repercussions such as fines, back taxes, and expensive litigation. You may also face potential lawsuits or other legal actions from workers who were misclassified.
When you misclassify workers, they often lose out on important benefits. For example, an employee who would be entitled to workers' compensation and unemployment insurance, as well as other benefits, wouldn't qualify for any of those if they were designated an independent contractor.
The Role of Legal Counsel
Accurate employee classification is a vital part of your business operations. To do so correctly, it's important to seek out a tax attorney who can help you navigate complex classifications.
At Kundra & Associates, we can help your business review its practices, provide compliance strategies, and represent you in disputes with taxing authorities, for a strong legal tax defense. If you're already facing a tax issue, it's essential to get legal help now. We provide tax defense and related support for clients in Maryland, Virginia, Washington, D.C., and internationally, and we can help you address your employee classification concerns, for accuracy and peace of mind. Get in touch with us today to receive quality support for your tax concerns.