Get it Right the First Time: Independent Contractor vs. Employee Status
How
does a business determine if its workers are employees or independent
contractors? This distinction is not as simple as most may think.
The
old adage of "My workers are subcontractors because they pay
their own taxes," is not one of the 20 questions that the IRS or state
labor agencies use to determine worker classification -- and that defense would
not ever carry any weight in an employment audit. In an era where worker
misclassification and due diligence requirements are at an all-time high,
accounting professionals must understand all the complexities. Improper
classification not only carries a huge burden on the business, but can also
have a significant impact on the worker.
If
the IRS determines employees were erroneously classified as independent
contractors, the IRS may notify the workers that they are not entitled to
deduct their business expenses from gross income on Schedule C and/or that they
were not entitled to contribute to a retirement plan because they are not
self-employed. When the IRS prohibits business expense and deduction claims for
contributions to self-employed retirement plans, it can be very costly to the
worker.
In
addition, when a business fails to properly classify its worker as employees,
these individuals are unable to participate in benefit programs, such as health
insurance provided by the employer. This issue, which usually arises after the
fact, can catch a worker by surprise and put them in a predicament that
oftentimes they are not prepared to resolve.
Yet,
the consequences and impact on the business are far greater than those for the
misclassified worker. In most cases, businesses categorize workers incorrectly
due to lack of knowledge and understanding of the guidelines. However, in some
cases, the misclassification is clearly willful and negligent. There are only
so many employments audits the IRS and state labor agencies can conduct, but
should a business that is negligent go through an audit, the consequences can
be quite severe.
For
example, a willfully careless business that has its workers misclassified will
not only be responsible for the tax liability, the penalty for improper
classification and the penalty for failure to file returns, but will also be
responsible for the 100% penalty for willful failure to collect tax. By the
time the audit case is closed, a business may owe three times as much just
for improperly classifying their workers.
Most
times, employment classification issues occur at the state level. In today's
tough economic times, workers will apply for unemployment compensation, which
triggers the state unemployment office to conduct an investigation when it
discovers that the business doesn't have the worker classified as an employee.
Other times, employment classification issues are triggered by workers'
compensation claims, or complaints to the state unemployment board about a
work-related situation. As I always say, it's the least expected situation that
can get a business under fire for worker misclassification.
While
it's quite clear what the consequences are to the business and the worker for
improper classification, it isn't always clear how a business determines if its
workers are employees or independent contractors. The key issue that the IRS
asks about is whether the business had "control" over the worker.
Control is the clear-cut word, but how control is determined is not so clear
cut.
In
order to determine if a business had control, the IRS will generally consider
20 questions in making the final determination of worker classification. Keep
in mind that not all these inquiries apply in every worker classification
audit. Often, the IRS will use only those questions that apply, depending on
the industry the business is operating in. Of these 20 questions, here are nine
that most businesses can use to make a fairly safe and correct classification
of their workers:
1.
Is the worker
required to comply with instructions given by the business?
2.
Does the business
provide the worker with training?
3.
Is there a
continuing relationship between the business and the worker?
4.
Does the
business provide set hours of work for the worker?
5.
Is the worker
required to have substantial hours towards the needs of the business?
6.
Who furnishes
the worker's tools and materials to conduct the work?
7.
Will the
worker realize a profit or loss from the services provided to the business?
8.
Does the
worker work for more than one business at a time?
9.
Does the
worker receive payment by the hour, week or month?
When
conducting worker classification audits, these are some of the questions that
are considered by the IRS and state labor agencies. Worker classification
audits have a case-by-case basis, so the degree of importance given to the
answers of each of the 20 questions will vary depending on the business and its
situation.
Remember,
too, that a business will be in an industry where IRS or court case rulings on
worker's status exist and set precedence. Therefore, it's not necessarily where
the business thinks their worker's should be, but rather what prior case
rulings dictate.
Helping
your clients understand the guidelines and properly classifying their workers
can prevent an audit, as well as save the business significant money in penalties
and interest. In addition, it can keep you, as the accounting professional, out
of the hot seat during these challenging times when the IRS is mandating higher
due diligence requirements. There is nothing better than getting it right the
first time!
About the Author
Andrew
G. Poulos, EA, is principal of Poulos Accounting & Consulting, Inc., in Atlanta, Ga.,
where he focuses working with tax clients and representing clients before the
IRS. Andrew is the producer of the QuickBooks Ultimate
Lesson Guide, a 16-hour DVD series teaching other accounting professionals
and small business owners QuickBooks basics. Contact him at
www.poulosaccounting.com.
