Rolling the Dice: Classifying Employees as Independent Contractors

There are a number of ways to hire someone, the two most common being a standard employer-employee relationship (with the associated employment tax obligations), or hiring  independent contractors to do the work, who are responsible for payment of their own taxes.

The tough economy has led many employers to classify (or reclassify) their employees as independent contractors, a move welcomed by many employees, whose paychecks are no longer diminished by statutory deductions.  Employers enjoy significant tax and worker’s compensation insurance savings, and employees get more money in their pockets.  Win-win, right?

Not surprisingly, the IRS disagrees, and in predictable fashion, it’s cracking down on the “independent contractor vs employee” question in a new enforcement program that will result in 6,000 random audits over the next three years in an effort to find misclassified employees.

And they’re going to succeed.  I’ve been conducting an informal survey, and so far I’ve found that as many as 30 percent of small businesses (those with ten or fewer employees; pizza joints, print shops, clothing boutiques, etc.) roll the dice, and, quite frankly, I can’t blame them.  The temptation to work with independent contractors instead of hiring employees is strong enough under ordinary circumstances, and in these grim times, when businesses may otherwise have to close their doors, many give in.  After all, if a company goes out of business, everyone winds up on the street, employer and employee alike.

It may help if small business owners understand the factors that the IRS considers in determining whether the individuals working for them are employees or independent contractors.  Perhaps changes can be made to the way the business operates that will support a finding that a worker is an independent contractor.

There’s no hard and fast rule, but one of the most important considerations is the degree of control and independence the worker is given over the work they perform.  Facts that provide evidence of the degree of control and independence fall into three categories:

1. Behavioral control:  Does the company control or have the right to control what the worker does and how the worker does his or her job?  Do you set the hours and place of work?  If so, the balance tips in favor of the worker being an employee.

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?

The IRS weighs all these factors during the course of an audit.  There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination.

However, many of the people I’ve surveyed seem to know the difference.  Their workers are required to clock in and out, they work at the employer’s location, using the employer’s equipment, and their activities are supervised by the employer.  In other words, there’s no room for doubt.   The odds of getting caught are naturally quite small, so many feel it’s worth it.  I really hope they’re right.

Author: Seth Heyman
Seth D. Heyman is a California attorney with extensive experience in advertising and marketing law, corporate law, contracts, governmental regulations, international business, and Internet law. He has counseled numerous successful companies, both public and private, and was responsible for regulatory compliance, contract management, corporate governance, and HR best practices for multiple organizations in many diverse industries, including marketing, telecommunications, energy, and technology development. He offers insight and guidance on federal and state direct mail, TV, radio, telemarketing, and Internet marketing laws, as well as online promotions, Internet privacy, data protection regulations, and similar matters.

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