By Ruth Beltran, EA
The classification of a worker is not necessarily the decision of a business owner. Federal and state authorities are very concerned with businesses that incorrectly classify their workers as independent contractors rather than employees. Many times, the misclassification of workers is simply a lack of knowledge. In some cases, the distinction “Independent Contractors vs. Employees” is very difficult to make. Unfortunately, many business owners rely on the common practice in their industries, which is not necessarily correct. However, the regulatory authorities perceive it as avoidance of payroll taxes, workers compensation, unemployment and other fringe benefits, which prompts repeated audits and hefty fines.
The defining factor here is control. A worker is an employee if the business owner has direct control as when, where and how the job is performed. The independent contractor performs his duties with no management or direction and the fruit of his labor can be accepted or rejected at the end.
The IRS bases its decisions in three factors:
Employee: Receives instructions as to how, when or where to do the work. Gets paid regular amounts at specific periods.
Independent Contractor: Works at his own schedule and uses his discretion as to how the job is completed. Is paid by the job or commission. Invoices the client for his work.
Employee: Has a lack of investment in the business and depends on the employer. Does not make his services available to the rest of the public, except through the employer. Receives reimbursement or payment for business expenses.
Independent Contractor: Has significant investment in his work. Can realize a profit or loss as a result of his service.
Relationship of the Parties
Employee: Works for the same employer for a continuous period. Can be discharged or end the relationship at any time.
Independent Contractor: Offers his services to the public and can work for various clients at a time. Agrees to complete a specific job. Is responsible for its satisfactory completion or is legally obligated.
As you can see, the IRS guidelines leave a lot of room for interpretation, but the states tend to follow them. And both tend to default into classifying the workers as employees when conducting an audit. The exposure intensifies when one of the workers lists the client as an employer when applying for unemployment benefits—unbeknown to them, they have triggered an audit!
Here are a couple of tips on how to define a worker and how to protect yourself in case of an audit:
- If the person being hired is incorporated, he is an independent contractor. However, be sure to obtain proof that he is in fact incorporated. Having a DBA (doing business as) and an employer identification number does not make someone a corporation!
- If the person being hired is not incorporated and you feel that he is an independent contractor, make sure to keep a current file with:
- Business card
- Copy of their website showing that they offer their services to the public. A list of clients as references.
- Their bill, which needs to be in a form of an invoice not a timesheet
- Copy of a contract or letter of engagement
- Copy of his workers compensation and liability insurance
- If you cannot obtain any of the above, they will be deemed employees.
- Be careful with your terminology—you are the employer of only the people who are on payroll.
Of course, there are certain staff positions that are clearly defined as an employee: your admin cannot be an independent contractor! Note that there is no mention of length of time the duties are performed. This is not a factor in this equation.
In addition, the business owner needs to be sure to comply with the requirements pertaining to each of these categories. If he is dealing with an employee, W-4 forms must be completed and W-2 forms issued at the end of the year, payroll taxes must be withheld and paid on a timely basis, and worker’s compensation and liability insurance must be in place. If he is dealing with an independent contractor, W-9 forms must be completed and 1099-misc forms issued at the end of the year, if required. This is also a hot topic with the IRS.
The ease of dealing with independent contractors is tempting; however, a business owner can seriously jeopardize the stability of the business by not clearly classifying the workforce. If the regulatory agencies decide that there was misclassification, they will review several years of compensation. The business owner will be liable to pay the employer and employee portion of the taxes plus interest and penalties—not a pretty proposition.
About the Author: Ruth Beltran is the owner of Beltran Accounting Services, LLC. Ms. Beltran has a BA from Middlebury College, an MBA from Fairleigh Dickinson University and has been an Enrolled Agent with the IRS. She has been servicing clients in the arts for two decades. Beltran Accounting Services is located in New York, NY.
About this article: This article first appeared in the Winter 2014 print edition of Resource Magazine, which is available here. It is the second part of a 3-part series: come back tomorrow to hear what a lawyer has to say about this important topic. Read here the words of wisdom of a producer who had to deal with the IRS and Unemployment Claims.