As U.S. companies struggle to recruit, hire, and retain talent, more businesses are turning to independent contractors instead of full-time employees. But understanding the difference between an employee and an independent contractor can be complex.

Getting it right is critical because misclassifying workers – intentionally or not – can result in penalties including, but not limited to, fines and back taxes. If the IRS believes a misclassification was intentional, there’s also the possibility of criminal and civil penalties.

There’s no single test at the federal level to determine a worker’s classification. Studies show that 10% to 20% of employers misclassify at least one employee. At its most basic level, the question boils down to this: Is the worker an employee or an independent contractor?

What the IRS Says

The IRS defines an independent contractor as someone who performs work for someone else while controlling how the work is done. The Internal Revenue Code defines an employee for employment tax purposes as “any individual who, under the usual common-law rules, applicable in determining the employer-employee relationship, has the status of an employee.”

Under this test, an individual is classified in one of the two buckets after examining relevant facts and circumstances and an application of common law principles. The IRS analyzes the evidence of the degree of control and independence through three overarching categories:

• Behavioral: Does the company control or have the right to control what the worker does and how they do their job?
• Financial: Are the business aspects of the worker’s job controlled by the payer? (How is the worker paid? Are expenses reimbursed? Who provides tools/supplies, etc.?)
• 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 a key aspect of the business?

No one factor stands alone in making this determination and the relevant factors will vary depending on the facts and circumstances.

If it is still unclear whether a worker is an employee or an independent contractor after reviewing the three categories of evidence, file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS. The form may be filed by either the business or the worker, and the IRS will review the facts and circumstances and officially determine the worker’s status.

The IRS cautions it can take at least six months to get a determination.

Penalties for Misclassifying

If the misclassification was unintentional, the employer faces, at a minimum, the following penalties:

• $50 for each Form W-2 the employer failed to file because of classifying a worker as an independent contractor.
• Penalties totaling 1.5% of the wages for the failure to withhold income taxes, plus 40% of the FICA taxes (Social Security and Medicare) that were not withheld from the employee and 100% of the matching FICA taxes the employer should have paid. Interest is also accrued on these penalties daily from the date they should have been deposited.
• A failure to pay taxes penalty equal to 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability.

If the IRS suspects fraud or intentional misconduct, it can impose additional fines and penalties. The employer could be subject to criminal penalties of up to $10,000 per misclassified worker and one year in prison. In addition, the person responsible for withholding taxes could also be held personally liable for any uncollected tax.

Tips for Employers

Take pre-emptive steps to avoid worker misclassification issues by:

• Examining the workforce to determine whether contractors are properly classified and, if necessary, taking remedial action.
• Setting up strict requirements for hiring contractors and be vigilant in meeting those requirements.
• Using a third party to screen and hire contractors. The contract with the third party should include a strong indemnification clause to protect the employer in the case of alleged misclassification.

Remember, a worker’s classification may be different under the Fair Labor Standards Act than under various state laws, the National Labor Relations Act, and/or the Internal Revenue Code. Workers who are properly classified as independent contractors under one state’s test may not be properly classified under another’s.

Employers should ensure proper classification of their workers and remain cognizant of and comply with applicable state and local laws, which may be different from federal law.

Does your organization need help classifying or ensuring your workers are classified correctly? Contact our team today!