Employees vs. Independent Contractors: The Trap for Employers

Defining an employee versus an independent contractor

As an employer, it is critical that you determine correctly which workers are employees, and which ones are independent contractors.

–Employee:  according to the IRS, “anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is true even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.”

 In other words, an employee is anyone you hire and for whom you provide office space, telephone, computer, supplies, and other tools to conduct his/her day tasks.  Also, the hired should be treated as employee if he/she is expected to follow a work schedule, and tasks set up by you –the employer or if they perform tasks similar to those performed by a current employee.

–Independent Contractor:  As a general rule again according to the IRS,” an individual is an independent contractor if you, the person for whom the services are performed, have the right to control or direct only the result of the work and not the means and methods of accomplishing the result.” Independent contractors should be marketing their services to other clients and have their own tools to get the job done.

Consequences of incorrect classification

Attributing the status of independent contractor to someone hired to perform services when he/she should be classified as an employee can be a genuine mistake, or done purposefully.  In these tough economic times it is a cost-sensitive decision, mainly because hiring an independent contractor results in not having to pay taxes, and/or benefits, which results in cost savings for employers.

Whatever the reasons may be, failing to properly determine whether a worker should be an independent contractor or an employee can have the following results:

-Workers classified as independent contractors when they should have been employees may not think about the self employment taxes, plus federal and state income taxes they will owe at the end of the year. But if at the end of the year they cannot pay their taxes they can simply tell the IRS that the employer inappropriately treated them as contractors when they should have been employees. Further they may claim unemployment benefits.  This can all lead to serious back tax liability, interest, penalties, and possible unwanted legal action.  You may also run into problems with garnishment issues.

-In the case of a classification dispute, the IRS usually does not give weight to the contract agreement entered between the employer and the independent contractor, or the issuance of the Form 1099. What matters is the nature of the relationship and the control imposed on the worker claimed as independent contractor.

To avoid severe penalties and qualify for protection under the law, an employer must meet all of the following three conditions: reasonable basis for classification, consistent treatment requirement, and return filing requirement.

• Reasonable basis may include the precedence based on the IRS published rulings, technical advice, judicial precedence, or a letter ruling or determination letter to an employer. Moreover, a prior IRS audit opinion, industry practice, or other reasonable basis may be used by the employer to defend its position.
• The consistent treatment requirement states that workers holding similar positions must be treated similarly. If the IRS finds that there is inconsistency in classification of workers, an employer will not be protected by the provisions of the law.
• The return filing requirement holds that an independent contractor must file all required tax returns and that the employment status used on those returns must be an independent contractor.  If this person fails to file the self-employment tax return, this failure may disqualify an employer from protection under the federal tax law provision. In addition, an employer must report all fees paid for the service to an independent contractor on the Form 1099.

As you can see, an employer does not have control over all three conditions required for protection.

The temptation of saving on employer tax expenses and fringe benefits should not drive this type of decision.  The short-term saving may result in a lengthy and time-consuming process of justifying the decision to the IRS or state unemployment office with the usually inevitable liabilities as a result.  Any cost-benefit analysis will show that it is not worth the potential savings.

Please consult us with any issues regarding the determination of employees versus independent contractors.  Each situation must be evaluated individually based on its own facts and circumstances.

Natalia Siegel, Senior Accountant and
Madina Traore, Bookkeeper