ISSUED 12/30/2020
Understanding the distinctions between an independent contractor and employee is crucial for all employers who wish to comply with federal and state tax and labor laws. A worker’s classification dictates how the business should proceed with federal tax payment. The IRS imposes different tax guidelines and requirements upon the business depending on whether the worker is classified as an independent contractor or an employee.
If a worker is deemed an employee, the employer withholds taxes from the employee’s pay, is responsible for paying social security, Medicare, and FUTA taxes on the employee’s wages, and issues a Form W-2. Additionally, the employer must abide by the Fair Labor Standards Act (FLSA), which includes compliance with minimum wage and overtime requirements. By contrast, if a worker is classified as an independent contractor, the business does not pay social security, Medicare, or unemployment compensation taxes. Independent contractors must receive a Form 1099 and are responsible for paying their own income tax and self-employment tax. Moreover, the business is not subject to the minimum wage
and overtime requirements for the independent contractor.
Additionally, properly classifying workers is essential to determining whether certain group health plan mandates, such as the ACA, COBRA, and Medicare Secondary Payer apply.
IRS Classification
For federal tax purposes, the IRS relies on three primary factors to determine whether a worker falls under an employee or independent contractor classification:
• Behavioral Control involves the extent to which the business controls how, when, and where the worker performs his or her services. A worker tends to fall into the employee category when the business directs and controls the way the work is done, which includes but is not limited to: selection of the tools and/or equipment and designation of permitted suppliers and services the worker may use. By contrast, a worker tends to fall in the independent contractor category when the business exhibits less control over the means and methods by which the worker carries out the work.
• Financial Control looks at whether the business aspects of the individual’s job are controlled by the payer.
Details such as how the worker is paid, whether expenses are reimbursed, who provides the tools/supplies, and whether the worker may realize a profit or incur a loss all help inform the proper classification. The less control the business has over the worker’s finances, the more likely the worker falls into the independent contractor category.
• Relationship of the Parties involves consideration of how the business and the worker perceive their relationship. Details that guide this inquiry include: the existence of contract or employee-type benefits, whether the relationship will continue, and whether the work performed is a key aspect of the business. The existence
of contracts outlining employee-type benefits, long-term or permanent projects and work that is integral to the business tend to place the worker in the employee category.
No single factor dictates whether the worker is an employee or an independent contractor. Rather, businesses must apply a case-by-case analysis of the extent to which they can direct, control, and document each of the factors used in reaching the determination.
DOL Classification
The Department of Labor also provides guidelines for classifying workers as either independent contractors or employees. For the Fair Labor Standards Act’s (FLSA) minimum wage and overtime provisions to apply to a worker, the worker must
be an employee of the employer. To determine whether a worker is an employee or independent contractor for purposes of wage and hour laws, the Department of Labor uses a multi-pronged “economic realities” test.
A worker who is economically dependent on the business more likely falls into the employee category whereas an economically independent worker may likely be considered an independent contractor. Similar to the IRS analysis, important factors that inform this determination include: whether the worker performs essential work or tangential work of the business, the worker’s ability to realize a profit or suffer a loss, work period length, control of the business over the method and means by which the worker performs the job, and whether the worker invests in equipment and facilities.
Ramifications for Misclassification
While misclassifying employees as independent contractors may be financially appealing to businesses, doing so can
pose significant issues for both the business and the affected workers. Unintentional misclassification can result in financial penalties for each Form W-2 the employer failed to file, payment of back taxes of as much as 41.5% of the employee’s wages, payment of back wages owed to employees, and interest accrued. If the IRS suspects fraud or intentional misconduct, the employer may also face additional penalties and fines, including punitive damages.
How to Remedy Misclassification
If an employer determines a misclassification has occurred, the IRS provides an opportunity for employers to reclassify their workers as employees. The Voluntary Classification Settlement Program (VCSP) allows taxpayers to voluntarily reclassify their workers as employees for future tax periods for employment tax purposes. Under the VCSP, a taxpayer will pay 10 percent of the employment taxes that would have been due on compensation paid to the workers being reclassified for the most recent tax year, calculated under the reduced rates of section 3509(a) of the Internal Revenue Code. To encourage participation in the program, the IRS will not audit the employer for prior years with respect to the reclassified worker and the taxpayer will not be liable for any interest and penalties on the payment under the VCSP.