Misclassifying workers is a costly mistake for a small business

As part of a five-year business plan, a small business owner decided to bring on workers as independent contractors. Depending on profitability, he thought he could then hire employees.

To the business owner's surprise, one of his independent contractors filed for unemployment benefits when an on-site project ended. An investigation by the state department of labor turned into a tax audit. The government agencies determined the worker was an employee. It also noted that several other workers had been misclassified. The owner had to pay thousands in employment taxes.

Independent contractor designation is often highly audited

The small business owner thought he understood the difference between an employee and independent contractor after reviewing the Internal Revenue Service guidance on the topic.

It turned out that he did not. Seeking advice from an experienced employment tax attorney might have avoided the situation.

Using independent contractors reduces administrative payroll burdens, because a company does not need to track and withhold federal, state or FICA taxes. The company provides contractors with Form 1099 at the end of the year listing the total amount paid on project work. A company generally avoids paying benefits to contractors as well.

For all employees, the employer must withhold trust fund payments - state, federal and FICA taxes and promptly send them to the IRS. An employer also pays half of the Social Security and Medicare tax for employees.

It is often difficult to determine worker classification correctly. As part of an information-sharing program, many state labor departments work with the IRS. If a worker is injured and seeks workers' compensation following an injury or unemployment benefits, it could prompt a state investigation into proper classification. Then in the case of a misclassified worker, it could trigger an IRS tax audit.

Questions to ask and red flags

When seeking to hire a contractor it is important to ask several questions. Does the individual provide similar work for other companies? Does the individual have a web site? Can he or she provide you with a W-9? Can the individual handle the project with little supervision?

The amount of control that a company maintains over a worker is important to the analysis. The IRS website lists the common law rules, which look at three main categories:

  • Behavioral - a contractor generally controls when he or she does work on a project and how it is completed.
  • Financial - independent contractors often provide bids. The contractor usually provides tools needed to complete the job and may take a profit or loss on a job.
  • Type of relationship - contract language may define the employment relationship. But this is not the only determination and will not override when a company controls work similar to that of an employee.

If a question about classification comes up, a lawyer can also advise on worker classification. When an individual should have been paid as an employee, the IRS has a Voluntary Classification Settlement Program that could reduce some penalties and bring a company tax compliant.

When your business is growing and you need more workers, consult a knowledgeable tax attorney regarding employment classification. A lawyer can also provide guidance through a labor department investigation or tax audit.