Employee misclassification is a growing problem. Some forms of misclassification occur when workers are not reported at all, such as by working off the books or being paid under the table in cash. Misclassification also occurs when employees are classified incorrectly as independent contractors. As an employer, it is very important that you properly classify the workers you hire as independent contractors or employees.
Why It Matters
Classifying your workers as employees or independent contractors carries important tax implications. Employers generally must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to employees. However, you typically do not have to withhold or pay any taxes on payments to independent contractors.
Employers who misclassify workers as independent contractors can end up with substantial tax bills. Additionally, they can face penalties for failing to pay employment taxes and for failing to file required tax forms.
Tips for Classifying Employees
The following tips can help you determine the status of your workers. In general, if you have the right to control or direct not only what is to be done, but also how it is to be done, then your workers are most likely employees. If you can direct or control only the result of the work done--and not the means and methods of accomplishing the result--then your workers are probably independent contractors.
1. Evaluate the Business Relationship
Although a contract may state that a worker is an employee or an independent contractor, this is not sufficient to determine the worker's status. The IRS is not required to follow a contract stating that the worker is an independent contractor, responsible for paying his or her own self-employment tax. How the parties work together determines whether the worker is an employee or an independent contractor.
In determining whether a worker is an employee or independent contractor, all information that provides evidence of the degree of control and independence must be considered.
2. Analyze the Degree of Control and Independence
According to the IRS, facts that provide evidence of the degree of control and independence for determining worker status fall into three categories:
- Behavioral Control: Behavioral control refers to facts that show whether there is a right to direct or control how the worker does the work. For example, an employee typically receives extensive instructions on how work is to be done (such as when and where to do the work, along with the order or sequence to follow when performing the work), as well as training about required procedures and methods.
- Financial Control: If you have the right to direct or control the financial and business aspects of a worker's job, the worker is more likely to be an employee. Workers who make significant investments in equipment used for the job, incur unreimbursed business expenses, or who can realize a profit or loss are more likely to be independent contractors.
- Type of Relationship: How the parties work together helps determine whether a worker is an employee or an independent contractor. For example, does the worker receive employee benefits such as health insurance or vacation pay? Will the relationship continue and is the work performed a key aspect of the business? If so, the worker is more likely to be an employee.
Remember that there is no set number of factors (or any one factor) which automatically labels a worker. The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.
3. Ask the IRS to Make the Determination
If a worker's classification is still unclear, the employer (or the worker) can file a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS. The IRS will review the facts and circumstances and officially determine the worker's status. Be aware that it can take at least six months to get a determination, but a business that continually hires the same types of workers to perform particular services may want to consider filing the form.
For More Information
For more information and resources related to determining worker status, visit our section on Independent Contractors--How to Classify or click on the Small Business link found on IRS.gov. If you have any questions, you should consult a knowledgeable employment law attorney or contact the IRS for guidance.
And for more tips on staying HR compliant, check out our free "Must-Do" HR Checklist featuring key steps for evaluating your HR practices.
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