A frequent question we get relates to employee classification. Small business owners and their employees often need clarification on the legal definitions of an independent contractor vs. an employee. The issue has tax, insurance, and potentially legal ramifications.
Introduction
An independent contractor is someone contracted to perform specific service for another business. Contractors are essentially their own companies, responsible for taxes, expenses, insurance, and equipment. Businesses that use contractors instead of employees can save some payroll taxes and other costs associated with hiring employees.
The classification is more complicated than simply calling someone an 'independent contractor.' The IRS recognizes these general categories of control and independence when defining a contractor:
1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
2. Financial: 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/supplies, etc.)
3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
When the hiring company controls what the worker does and how, is in charge of the business aspects of engagement, and if the relationship is like employment, the hire is really an employee--no matter what they call it. However, there are not a clearly defined set of standards that identify when it is contracting and when it is employment. The IRS makes this judgement on a case by case basis, thus the issue frequently comes up in audits.
Issues
The IRS, and other regulatory agencies, look for misclassified employees for several reasons, some of which can be very costly.
Taxes: A 'contractor' who should really be an employee pays 7.5% of their income in payroll tax. Although they see some benefit, it can be an onerous expense. Employers typically pay this half the employment tax, a cost above and beyond the wages paid.
Insurance: People inappropriately classified as contractors are not covered by the workers' compensation insurance carried by employers. Independent contractors should carry their own insurance for on the job injuries. Employers should be careful: workers comp audits often focus on inappropriately classified (and thus uncovered) workers.
Misclassification: If the IRS audits a business and discovers workers misclassified as contractors, employers may be forced to pay past employment taxes as well as penalties and interest.
Advice
It is important to understand the risks to you (the small business owner) of misclassified workers. This issue alone could jeopardize your entire business operation. The costs you could face for treating employees as independent contractors could force you into closing your business. You should fully understand the tax costs and insurance risks surrounding the issue, and take appropriate steps to mitigating those risks.
As always, we recommend planning ahead of time and keeping good records. Especially for independent contractors, because some business expenses can be deducted from business income. A sound tax strategy complemented by solid records makes preparing and filing the tax return easier (thus cheaper).
Written contract: Use a written contract to clarify your intent and working relationship with a contractor. While a contract alone is not enough to confirm 'independent contractor' status, it can be helpful in outlining how the relationship fits that status.
Insurance: If you are in an industry with heavy manual labor or risk of injury, or an industry that normally has workers compensation insurance, contact the appropriate state agency to determine who needs to be covered under such a policy. Sometimes independent contractors for tax purposes may be treated as employees for workers comp purposes.
Forms: Independent contractors that are paid more than $600 in a year must be provided with a form 1099-MISC at the end of the year. Independent contractors rely on the reported amount and their expense records to determine their income for tax purposes.
Resources
The IRS links to guidelines
SCORE, a non-profit that organizes small business education, has this helpful article
Legal Zoom advice (While not a law firm, Legal Zoom sells standard legal documents.)
Agencies Responsible for Labor Issues
Maine Department of Labor
Maine Workers' Comp Board
Maine Revenue Service
Federal Department of Labor
Internal Revenue Service
