Most successful small business owners are at some point confronted with the decision whether to hire additional help. Though the prospect of adding to a company’s human resources can be an exciting step in the growth of a business, it should be accompanied by a number of important considerations. One of these is whether the new hire should be an employee or an independent contractor. The distinction is an important one.
Because of the labor cost savings, reduced liability, and flexibility in hiring afforded by using independent contractors, many small businesses choose to rely on independent contractors rather than hire employees. Independent contractors, unlike employees, are not covered by federal or state wage and hour laws, and they are ineligible for employee benefits such as health insurance and company retirement plans. Also, employers are not required to pay Social Security, Medicare, and unemployment taxes for independent contractors. Instead, independent contractors are responsible for paying their own income tax and self-employment tax.
Companies that employ independent contractors can run into trouble, however, if they misclassify employees as independent contractors. Misclassification of a worker as an independent contractor can have several significant consequences, including: reimbursement to the misclassified employee for wages he should have received under the Fair Labor Standards Act, including overtime and minimum wage; liability for unpaid income, Social Security, Medicare, and unemployment taxes; payment of any workers’ compensation benefits the misclassified employee may be entitled to; and a requirement to provide employee benefits, including health insurance and retirement benefits, to the misclassified employee. Accurately classifying a worker allows an employer to avoid these costly consequences.
Classifying a particular worker as either an employee or an independent contractor is not always an easy task. Determinations must be made on a case-by-case basis, taking into account all relevant facts and circumstances of a specific case. Some factors may indicate that the worker is an employee, while others may suggest that the worker is an independent contractor. There is no magic number of factors that “makes” a worker an employee or independent contractor, and no one factor stands alone in making the determination. To further complicate matters, the test for determining whether a worker should be classified as an employee or an independent contractor may vary depending on the agency with which you happen to be dealing (IRS, Department of Labor, Industrial Commission, etc.). While this article specifically discusses factors used by the IRS, most (if not all) of these factors are similarly applicable in other contexts.
Generally, an employee is an individual who performs services for an employer and is subject to the employer’s control regarding what will be done and how it will be done. In contrast, an independent contractor is an individual who performs services for the employer but is not subject to the employer’s control with respect to how the work will be performed. In determining the degree of control and independence in a business-worker relationship, three categories of evidence are typically considered: (1) behavioral control, (2) financial control, and (3) the type of relationship between the parties.
Factors considered under the behavioral control category include the degree of instruction provided by the business, the type of instruction given, whether (and if so, how) the worker’s performance is evaluated, and the nature of any training provided by the business. For example, instructions from the business concerning how a task should be performed, mandatory trainings or meetings, and the use of regular reports and performance evaluations would be indicative of an employee-employer relationship. It is important to remember that the key inquiry is whether the business retains the right to control the worker’s behavior, regardless of whether the business actually exercises that right.
Evaluating the financial control afforded the worker involves such questions as: Has the worker made a significant investment in his own facilities or equipment (tools, supplies, etc.)? Does the worker incur expenses for which he is not reimbursed? Is there an opportunity for the worker to realize a profit or suffer a loss as a result of the services performed? Does the worker offer his services to other businesses on a regular and consistent basis? Is the worker paid on a regular, periodic basis (by the hour, week, day, month, etc.)?
The type of relationship between the business and the individual worker must also be considered. One should ask: Is there a written contract between the parties? Is the worker provided employee-type benefits such as a pension plan, insurance, or vacation pay? Is the relationship between the parties a continuing one? Is the work being performed a key aspect of the business?
Recently, the United States Tax Court applied these various factors in a case involving workers hired by a construction company to work on various residential construction projects. Kurek v. Commissioner, T.C. Memo. 2013-64. Despite the fact that the workers set their own hours, provided some of the tools for the work, worked on a project-by-project basis, were free to work on other projects with other construction groups, and believed they had created an independent contractor relationship with the sole proprietor of the construction company, the Tax Court determined that the workers were employees. In reaching this conclusion, the Tax Court relied on the following facts: the sole proprietor of the company set deadlines for the workers and monitored the work being done, visited the work site daily or every other day; had ultimate authority in instructing the workers with respect to the work and had the right to approve the quality of their work; paid them weekly rather than at the end of a project; the workers were paid a negotiated flat fee; the sole proprietor could discharge any worker who did not meet a deadline or did not perform to the sole proprietor’s satisfaction; and without the workers the company could not have sustained its normal operations.
As Kurek illustrates, businesses should weigh all of the relevant factors when determining whether a worker is an employee or an independent contractor. In doing so, they should look at the entire relationship and document each of the factors used in making the determination. It also may be necessary to re-evaluate a worker’s status if the facts and circumstances surrounding his relationship with the business change over time.
If, after reviewing the facts and circumstances, it is still unclear whether a worker is an employee or an independent contractor, a business or worker can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding with the IRS. Based on the information provided in the form, the IRS will make an official determination regarding the worker’s status. Be advised that it can take six months to obtain a determination from the IRS, but for a business that continually hires the same types of workers to perform certain services it may be worth the time and effort.
Once a determination is made regarding a worker’s status as an independent contractor or employee, the appropriate forms must be filed and the associated taxes paid. Information on the forms and associated taxes for independent contractors can be found here (http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Forms-and-Associated-Taxes-for-Independent-Contractors). Information on the forms and associated taxes for employees can be found here (http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Hiring-Employees) and here (http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Employment-Taxes-2).
If a business misclassifies a worker as an independent contractor, all is not lost. By meeting certain requirements a business that has misclassified an employee can obtain relief from paying unpaid employment taxes under section 530 of the Internal Revenue Code. First, the business must have had a reasonable basis for not treating the workers as employees. A reasonable basis can include: a court case involving federal taxes or a ruling issued to the business by the IRS; an audit in which the IRS did not reclassify similar workers as employees; an industry standard of treating similar workers as independent contractors; or the advice of a lawyer or accountant who knew the facts about the business. Second, the business must have consistently treated the worker, and any similar workers, as independent contractors. Third, the business must have filed all required federal tax returns (including information returns) consistent with its treatment of each worker as not being an employee.
Finally, even if a business does not meet the relief requirements of section 530, it may nonetheless receive partial relief from paying federal employment taxes by participating in the Voluntary Classification Settlement Program (VCSP), an optional program that provides taxpayers with an opportunity to reclassify their workers as employees for future tax periods for employment tax purposes. For more information on the VCSP, including the eligibility requirements and a link to the “Application for Voluntary Classification Settlement Program,” go to http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Voluntary-Classification-Settlement-Program.
Determining whether a worker is an employee or an independent contractor is critical to a small business attempting to assess its employer obligations. Making an incorrect classification can have significant economic consequences. As a result, businesses should carefully consider a worker’s status before making a classification and routinely review independent contractor arrangements to ensure that those relationships have not become employment relationships. By working through these complex issues with competent legal counsel, companies can reduce their exposure to the risks associated with incorrectly designating employees as independent contractors.
By Ammon Taylor