Independent Contractors Vs. Employees

The US Government estimates that approximately 3.5 million employees are classified as independent contractors when they are in fact employees in each year.  This misclassification costs the US Government approximately $55 billion of income taxes and $15 billion of unpaid FICA and unemployment taxes in each year.  For this reason, on-going efforts have been made by the US government to detect misclassification of employees during income tax audits.  Additionally, many state governments have implemented their own examination process to minimize their state tax revenue loss due to the misclassification.

Many employers misclassify employees as independent contractors for a simple reason of saving tax money.  Misclassification can save substantial amount of expenses including employer’s share of Social Security and Medicate taxes, overtime pay, unemployment compensation tax, and workers’ compensation insurance.  However, this practice can cause substantial amount of taxes, penalties and interest, and perhaps criminal charges in some cases, in addition to the potential claims by employees for unpaid compensations (including overtime pay, sick pay, vacation and holiday pay).  Let’s break down the potential tax penalties that employers may face if the misclassification is found to be unintentional:

• $50 for each reported W-2.
• 5% failure to withhold income taxes.
• 40% of employee share of FICA taxes.
• 100% of employer share of FICA taxes.
• Up to 25% of failure to pay tax penalties.

IRS looks at degree of control exercised by the employee in determining whether or not a worker is an employee or independent contractor.  Generally, there are three factors, under the Common Law Rules, that should be carefully reviewed in classification.  They are:

• Behavioral Control – Does the payer control or have the right to control what the worker does and how the worker does his or her job?
• Financial Control – Are the business aspects of the worker’s job controlled by the payer? These include things like how worker is paid, whether expenses are reimbursed, who provides tools and supplies, etc.
• Type of Relationship – Are there written contracts or employee type benefits?

If determination of employee or independent contractor based on the above mentioned factors is unclear, payor can submit Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, and IRS can officially determine the worker’s status.

Also, payors do not have to cover independent contractors under workers’ compensation insurance, and not liable for payments under unemployment insurance, disability insurance, or social security with the state taxing authorities.  Misclassification may expose employers for sever penalty provisions by state government and there are many state agencies (including the Employment Development Department, Division of Labor Standards Enforcement, Franchise Tax Board, Division of Workers’ Compensation, and the Contractors State Licensing Board) with their own regulations or requirements concerning independent contractors enforcing proper classifications.

Take Away

Because the potential liabilities and penalties are significant if an individual is treated as an independent contractor and later found to be an employee, each working relationship should be thoroughly researched and analyzed before it is established.