CONSTRUCTION Accounting ARTICLE - Are You Mishandling Your Independent Contractors?
The IRS is watching more closely than ever
Target Audience: Construction Industry Professionals, General Contractors, Construction Accountants
For many years now, the IRS has been monitoring, in some cases challenging, employers’ handling of independent contractors. At issue: the agency’s contention that some companies are misclassifying employees as independent contractors.
The IRS has gone as far as to undertake a formal national research project to study independent contractor use as well as fringe benefits and various payroll issues. And construction companies — with their various subcontractor and project-specific, specialist relationships — are particularly in danger of running into classification troubles.
Paying the taxes
One of the major differences between a conventional employee and an independent contractor comes down to taxes.
Payments you remit to independent contractors aren’t subject to withholding of payroll or income taxes, and you don’t have to pay the employer share of FICA or Medicare taxes either. You also aren’t subject to unemployment or workers’ compensation insurance requirements.
What is prompting all of the IRS attention to businesses’ use of independent contractors? Worker misclassification diminishes federal income revenue by billions of dollars annually, according to the IRS. This is likely because, even though workers classified as independent contractors are subject to self-employment taxes, they tend to underreport their income and often don’t pay into unemployment and workers’ compensation programs. Naturally, states also lose tax dollars — and many are taking action.
Making the distinction
When scrutinizing a company’s independent contractor arrangements, the IRS typically looks at three general categories.
The first one is behavioral control: When, where and how a job gets done. If you direct the work — meaning you require the individual to perform the work on your job site or at your office, at a set time and according to your processes or on your equipment — that person is more likely to be classified as an employee by the IRS. If you define only the outcome of the work and the worker is free to achieve that outcome as he or she sees fit, the individual probably is an independent contractor.
The second category is financial control. Here the IRS examines how much an individual controls financial aspects of his or her work. For example, if a worker has ongoing expenses that aren’t reimbursable (such as investments in facilities, tools or equipment), can market his or her services to others, and is in a position to experience a profit or loss on a particular project, the person likely is an independent contractor.
The third and final category covers the relationship between the parties. This category considers how the business relationship is structured. Independent contractor arrangements typically include a contract for a particular timeframe and a specific outcome for a set fee. Conversely, employees generally handle a broader array of duties and may be paid benefits in addition to wages or salary.
Correcting the mistake
If you fear you’ve misclassified an employee as an independent contractor, don’t panic. Internal Revenue Code Section 3509 may allow you to reduce or escape liability by correcting the mistake and submitting proper documentation to the IRS.
You might also look to Sec. 530 of the Revenue Act of 1978 for relief of employment tax liability for worker misclassification. Under it, you may escape penalties if you can show you had a reasonable basis for classifying the worker as you did, treated the worker and all similar workers as independent contractors and filed Form 1099-MISC for the worker.
Remaining vigilant
You may have grown comfortable with your handling of subcontractors or other short-term specialists who work on your job sites or in your office. But you’ve got to remain vigilant: A long-term project or a key technicality in the arrangement could draw IRS attention.
If you’re concerned some of your independent contractors could be reclassified as employees — or you’re not sure whether a new worker qualifies as an independent contractor or should be treated as an employee — your tax advisor can help you assess the situation.
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