Business owners who unwittingly or deliberately misclassify employees can end up in an employment tax dispute with the Internal Revenue Service (IRS). Avoid the inevitable confrontation by knowing the differences between an employee and a legitimate contractor.
What is the problem?
Employers have an obligation to withhold and report payroll taxes, pay workers’ comp, and pay the employers' share of federal and unemployment taxes. There is generally no such obligation with an independent contractor. To avoid the outlay, some business owners misclassify their workers as independent contractors. Sometimes, the line between a worker and a contractor is so thin that it must be determined by a court—but for the most part, some bright lines offer guidance as to when an employee is just an employee and not a contractor.
To determine whether a worker is a contractor or an employee, the IRS looks at different factors like how work is assigned and performed, and how the working relationship is defined. Consider these points:
- Working relationship: If a worker is eligible for benefits such as health insurance, paid leave, and other perks, it signifies a type of relationship that does not exist with an independent contractor. Contractors are responsible for their own benefits and their relationship with a business may be carefully (or not) defined by contract.
- Character of work: The “right to direct or control work” is a strong indicator of an employer/employee relationship. If a worker is classified as an independent contractor but is trained, supervised, and instructed by an employer—the worker may be misclassified, even if they do not receive employee benefits. Independent contractors are generally expected to obtain their own training, confer with a business owner on the work required, and then undertake that work in a self-directed way.
- Economics: Independent contractors must manage their own business and may have an investment in their company. Unless written into a contract, independent contractors are generally not reimbursed for business expenses. Contractors also negotiate with business owners for their fees and carry responsibility for the profit or loss of their own businesses. Employees are generally reimbursed for business expenses, accept an agreed-upon salary or wage offered by the employer, and in the most specific sense, do not control the profit and loss of the company of their employer.
Knowing the difference between a contractor and an employee can save you penalties and additional tax liability for misclassified workers. If you have questions about employee classification or are involved in an employment tax disagreement with the IRS—talk to an experienced tax attorney for guidance.
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