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Misclassifying Workers Can Be Costly!

Misclassifying

Most business owners and executives tend to be financially conservative and preserve the cash of the business. This conservative approach frequently carries over to hiring activities, with many employers choosing to hire independent contractors/freelancers as opposed to full-time employees. In doing so, they eliminate the cost of company benefits such as vacation, sick pay, health insurance and retirement funding. Another big benefit is eliminating the employer’s matching share of Social Security and Medicare payroll taxes, not to mention the savings on unemployment taxes and worker’s compensation insurance.

Eliminating all those costs associated with employees and hiring independent contractors may save a lot of money, but it can also be a minefield. Just because you pay a worker like an independent contractor does not necessarily make him one. And if you are subsequently challenged on that classification by the IRS or your state taxing authority, and lose, you will pay back all those savings plus penalties and interest. The company’s retirement plan could also be in jeopardy of losing its qualifying status if workers who should have been eligible to participate have been excluded from the plan. The line between independent contractor and employee is not always clear, but the following are some guidelines that can be used in making the determination.

The three primary characteristics the IRS uses to determine the relationship between businesses and workers are: Behavioral Control, Financial Control and the Type of Relationship.

  1. Behavioral Control – Relates to facts that show whether the business has a right to direct or control how the work is done through instructions, training or other means.
  2. Financial Control – Relates to facts that show whether the business has a right to direct or control the financial and business aspects of the worker’s job.
  3. Type of Relationship – This factor relates to how the workers and the business owner perceive their relationship.

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.

Here are some additional factors to consider when making a determination:

  • Sole Employer – An independent contractor is in business for him or herself and generally will have additional clients for whom services are provided. If you are the only client and he or she is not actively pursuing work from others, then it becomes an indicator favoring employee status.
  • Work Schedule – Independent contractors generally set their own work schedule. Requiring the worker to maintain regularly scheduled work hours is an indicator of employee status.
  • Materials & Supplies – Independent contractors generally provide their own materials and equipment and invoice their clients for labor and materials. If you provide all of the material and supplies, that is another indicator of employee status.
  • Work Location – Another indicator of employee status is when a worker performs services only at your work location and does not maintain an office or facilities elsewhere.

If, after considering all the factors and issues, you feel you cannot reach a definitive determination, then you, as an employer, can request the IRS to make a determination on whether a specific individual is an independent contractor or an employee by filing a Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) with the IRS. However, the IRS does not issue determinations for proposed or hypothetical situations. A worker may also file Form SS-8 requesting an IRS determination.

A word of caution: if a worker that you classified as an independent contractor is subsequently determined to be an employee, you will be open to a lawsuit for back benefits or even other demands related to the worker’s specific circumstances.