Construction Accounting Article -
How To Classify Independent Contractors vs. Employees

Target Audience: Independent Contractors, IRS Guidelines Interest, Employer Hiring Trends Interest, Contruction Accounting Firm Interest

There are significant benefits to the employer hiring independent contractors. However, the classification has become more of an art. The cost in misclassifying an employee as an independent can be sever. As case in point involved Microsoft Corporation. In this much publicized case, the IRS reclassified a number of the software giant’s independent contractors as employees, costing Microsoft millions in penalties as well as back employment taxes and benefits. This case shed a chilling light on the once-seemingly harmless practice of hiring independent contractors to cut employment costs. Here’s a closer look at how to keep your company safe from the dangers of misclassifying workers.

Upsides and Downsides

Some might say that avoiding Microsoft’s dire fate is simple: Just don’t hire independent contractors. However, some undeniable good reasons exist for doing so. For starters, you don’t have to withhold income and Social Security taxes from their pay or owe matching Social Security taxes. You also may forgo including them in employee benefit arrangements, such as profit-sharing plans, qualified pension plans or stock-purchase plans. Nor must you give them vacation and sick days, or pay for insurance and other fringe benefits.

The downsides? Well, as the Microsoft case showed, the IRS often challenges companies it believes are trying to circumvent payroll taxes by classifying actual employees as independent contractors. And if it can prove you’re misclassifying workers, you may be subject to serious consequences.

First, you’ll need to file and pay the back payroll taxes. The IRS can also hold you liable for several different fines or penalties, ranging in severity from 1.5% to 3% of wages paid to a criminal penalty of $100,000 and/or five years in prison for willfully or intentionally misclassifying workers to evade employment taxes. And, like Microsoft, you may be required to pay the full amount (both the employee’s and employer’s share, as applicable) of contributions owed to pension plans - retroactive to the date the person was first paid as an independent contractors instead of an employee.

IRS Guidelines

The best way to avoid these harsh effects is by going straight to the source. Although statutes don’t define "employee" for income tax purposes, the IRS applies a common-law test embodied in Treasury Regulation (31.3121(d)-1(c)(2)) to classify workers.

The IRS classifies workers primarily based on whether the employer controls what they do and how they do it. To clarify this often fuzzy distinction, the IRS has traditionally published a list of 20 factors derived from the common-law test. These factors ask you to contemplate various aspects of an independent contractor’s relationship with you, such as whether the worker:

• Works for more than one company at a time,
• Offers services to the general public,
• Supplies his or her own tolls and materials, and
• Hires, supervises and pays assistants.

Independent contractors do these things, regular employees don’t. Conversely, you also need to look at activities that would disqualify an independent contractor, such as whether he or she received training at - and appears integrated into - your company. In addition, does he or she follow work sequences you set and personally provide these services on your premises? Do you require the independent contractor to work full time, and do you pay him or her hourly, weekly or monthly wages? Answering "yes" to any of these questions doesn’t necessarily indicate the worker is an employee. But it could mean trouble, depending on your situation.

Bear in mind, the 20 factors are guidelines - not hard-and-fast rules, and not all factors are relevant in every case. The IRS has the discretion to make conflicting decisions, using the factors to support its choices. And some IRS examiners view them differently than others, depending on the job and circumstances.

Compliance Tips

Your safest course of action is to establish clear procedures for how your company controls an independent contractor’s activities and compensates him or her for them. Pay those workers by the job and only when they submit invoices to you. Don’t pay them a weekly or monthly salary. Each year end, file a Form 1099 for each independent contractor to whom you paid at least $600 during the year.

Moreover, familiarize yourself with the professionals who customarily act as independent contractors. For instance, practitioners such as doctors, lawyers, architects, accountants and consultants commonly perform as short-term workers for specific kinds of cases and projects. Similarly, creative freelancers (such as editors and programmers) and tradespeople (such as carpenters and plumbers) are usually accepted as independent contractors. If your company hires these types of workers, you’re more likely to convince the IRS that they’re not really your employees. But don’t rely on that alone.

Also check to see whether businesses similar to yours have successfully defended themselves against IRS worker reclassification. In some circumstances, a safe haven rule - dealing with only employment taxes - exists. It protects taxpayers that consistently treat workers as independent contractors, but doesn’t apply to technical workers. To qualify, you must meet certain tests - such as having a reasonable basis for treating workers as independent contractors. One defense is a long-standing practice in your industry. But watch out: The IRS may come calling if your company reports significantly more independent contractors compensation than is standard in your line of business.

Classification Confusion

If you find the worker classification rules confusing, or at least intimidating, you’re not alone. Many companies struggle with this issue. What’s worse, the IRS isn’t alone in its scrutiny of independent contractors. Massachusetts has its own set of rules for determining independent contractor status that are much more restrictive and rigid than the federal rules. Give us a call to learn more about how the rules may apply to your situation and steps that you may take to reduce your exposure.

Find out how our expertise in construction accounting can add value to your business. Email us or call us at 1 (888) 875-9770.

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