Independent Contractor or Employee?

08/22/08

You’ve started to advertise more, so you hire a graphic artist to produce ads for you on a monthly basis. You only need him twenty or thirty hours a month, and you don’t want to add to your payroll costs. So you and he agree verbally that he’s an independent contractor.

But you have a spare room and computer, so you tell him he can produce the ads at your workplace. That’ll make it easier to direct the work, for one thing. For another, you can make sure he does it using your software, which you know is compatible with the printing house you use.

After a year or so, the relationship runs its course and you dismiss him. You forget all about it until an IRS auditor comes in and reclassifies that “independent contractor” as an employee. You owe back taxes, interest, and ouch penalties. To make matters worse, you have to cover the worker in your pension plan retroactively.

It might seem obvious to you, a seasoned HR professional, that this is a clear employee-employer relationship. But the IRS uncovers cases like this all the time as well as many that hinge instead on subtleties that baffle even the well informed. And misclassifying a worker can have serious consequences: The IRS reclassified 527,000 workers in 13,000 audits be-tween 1988 and 1995 (the latest years for which figures are available), resulting in $830 million in new tax assessments.

This article will help you understand just what an independent contractor is—and how to avoid the tax penalties that can come as a result of misclassifying those who perform work for you.

Why the Government Cares
First, understand what’s at stake. An employer, of course, has to withhold income and other taxes, as well as pay unemployment taxes and half of an employee’s Social Security and Medicare taxes. But you don’t have to do any of these things when you hire an independent contractor. That makes it awfully tempting to call anyone who does project work for you a contractor.

The Internal Revenue Service cares a great deal about how you classify the people who perform work for you. A lot of money rides on your decision.

Statistics from the Government Accounting Office show, for instance, that in 1997 the self employed owed nearly $7 billion dollars in delinquent taxes. And an IRS analysis concluded that the compliance rate for paying Social Security and Medicare taxes is over two times higher for those working for an employer than for the self-employed. In other words, the government is much more likely to get the money it is owed if an employer is collecting taxes for it.

And the IRS isn’t the only government agency that cares how you classify employees, by the way. Your state’s tax department is equally concerned. So is the EEOC, because employers are not subject to most discrimination laws until they reach fifteen or twenty employees. How you classify employees may thus become part of an investigation.

Then there’s the U.S. Department of Labor, which has its own guidelines. Penalties for misclassification can be substantial under wage-and-hour laws. Finally, your state’s workers’ compensation bureau may deny benefits for misclassified, injured workers, leaving you open to a lawsuit.

Employee vs. Contractor
So how do you know how to classify workers and stay within the law? According to the IRS, you consider a number of factors that fall into three categories:

1. Behavioral Control. Do you have the right to direct and control the worker? If so, he or she is an employee. You direct and control to the extent that you can tell a person when to do the work, how to do it, what tools to use, where to buy supplies or other services, what routines or sequence to follow, and so forth.

2. Financial Control. Do you reimburse expenses? Independent contractors usually absorb many expenses. Does the worker have a significant investment in facilities or tools? Most true contractors do. Does the worker advertise and accept jobs from other organizations? It’s a red flag if the contractor works only for you or if you discourage him or her from taking on other jobs. Do you pay the worker hourly or in the form of a flat fee? Most contractors get paid by the job, not by the hours they put in. (Exceptions: lawyers and some other professionals.) Is the worker at risk for taking a loss or making a profit? Contractors generally are.

3. Type of Relationship. Do you offer the worker insurance or other benefits? This signifies an employer-employee relationship. Do you have a written contract spelling out the nature of the relationship? Defining in writing the worker’s status as an independent contractor is always a good idea. Does the worker consider the relationship permanent? Contractors generally go from project to project they don’t expect that an organization will continue to feed them work over a lengthy period of time.

Look at the Whole Picture
The IRS goes out of its way to remind us that no one factor, by itself, guarantees that a worker should be classified as a contractor or employee.

The IRS looks at the totality of the relationship. That “totality” is embodied in the “Twenty Factors” list on page 5. It is one way the IRS analyzes work relationships to gauge whether you’ve properly classified them. Using it can therefore help you classify a worker properly, or demonstrate ways to keep the relationship at arm’s length and thus preserve the worker’s contractor status.

You can also ask the IRS itself for guidance. Form SS-8 is a three page form called “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” (You can get SS-8 directly from G.Neil.) Filled out, the form gives an IRS auditor enough information to recommend a classification for a worker.

Finally, Hiring Independent Contractors and the tip card can keep you on safe ground.

Settle in a Safe Harbor
If the IRS targets you for a classification audit, you can avoid paying back taxes and penalties if you meet all of the following requirements:

1. You had a reasonable basis for not treating the workers as employees. For instance, you relied on a court case IRS opinion; your industry always treats similar workers in this manner; or you relied on the advice of an attorney who knows your business well.

2. You must have always treated such workers as independent contractors.

3. You have always filed 1099-misc forms for the workers in question. If you don’t qualify for relief under these “safe harbor” provisions, that does not mean you’re automatically headed for trouble. The IRS examiner will look at the relationship based on the twenty factors and other indications that may suggest an employer-employee relationship.

In addition, your state’s laws may have a bearing on the situation. Missouri, for example, specifically excludes the safe harbor mentioned above when determining whether a person is an employee or contractor.

Toe the Line
The Society for Human Resource Management contends, “The current 20 part test for distinguishing between employees and independent contractors is counter-productive and the complex requirements detract from efforts to make American companies more productive.”

There are some in Congress who would like to make it easier to define a worker as an independent contractor, or at least remove some of the ambiguity. But with so much money at stake, change will be hard to come by. Until then, it’s best to toe the line. With the IRS keeping its eye out for misclassifications, you can’t afford to do otherwise.