From the Desk of Michael T. McCormick
Employee VS Independent Contractor
I enjoy fielding questions from clients. For my next several Friday Tax Tips I am going to write about some recurring questions that have broad appeal to many of my clients. Today I am going to address the issue of whether you are an employee or independent contractor. This is critical from both the perspective of the company as well as the individual doing the work. Currently, the likelihood of your business being involved in a worker classification or employment tax audit is increased because the IRS is aggressively attempting to reduce the “tax gap,” which is the annual shortfall between taxes owed and taxes paid. I can write an entire treatise on whether there is in fact a “tax Gap” but I will save that for a later missive.
Because the existing worker classification rules are complex and ambiguous, much uncertainty surrounds their interpretation and application. The lack of a single, definitive test for classifying workers as either employees or independent contractors contributes significantly to the worker classification problem. I find that one can select a host of similar companies employing similar people to do a given job and each company handles that worker differently. This is not necessarily by design but rather because of the complexity of the analysis that gets the company in trouble. Therefore, understanding the difference between an employee and an independent contractor is very important. If you are an employer, you are required to withhold and contribute a matching amount of FICA and Medicare taxes from your employee’s income. However, if your workers are independent contractors, you are only required to report payments of $600 or more on a Form 1099-MISC (Miscellaneous Income). As a general rule company’s prefer to class workers as independent contractors to save money. However, failing to make the right classification could cost you money.
If you have workers who make substantial financial investments in tools, equipment, or a place to work, or undertake some entrepreneurial risks, they are probably independent contractors. However, when you control and direct the workers who perform services for you as to the end result and how it will be accomplished, you are probably involved in an employer-employee relationship. Additionally, if you have a worker who also works for other companies then they are likely considered independent contractors. Unless there is a reasonable basis for treating your employees as independent contractors, failing to withhold income and employment taxes from their wages can result in severe penalties and interest, in addition to the back taxes owed. Of course, penalties for intentional worker misclassifications are harsher than they are for inadvertent mistakes.
Your benefit plan may also be in jeopardy if any eligible employees have been misclassified as independent contractors. Since these employees have been excluded from plan participation, your retirement plan may lose its tax-favored status. The problem is compounded when excluded employees seek restitution for lost benefits not only due to their exclusion from the benefit plan, but also for health coverage and other employee benefits.
The IRS offers an amnesty program to eligible employers that have misclassified workers. This program, called the Voluntary Classification Settlement Program (VCSP), allows employers that are currently treating their workers (or a class or group of workers) as independent contractors or other nonemployees to prospectively treat the workers as employees, at a cost that is 10 percent of what would normally be owed in a worker misclassification situation. In addition, a safe harbor rule known as “Section 530” provides relief from employment tax obligations with regard to workers, even though those workers may be common-law employees, if certain requirements are met. Since the potential liability is considerable, it is critical for you to verify that your workers are properly classified. If misclassifications are discovered, we can help you minimize your exposure through use of Section 530 relief or the VCSP. It is also important to review your employment tax records and procedures to ensure that they are in compliance with IRS guidelines, especially in the event of an audit.