Many employers mistakenly believe that the misclassification of employees as independent contractors doesn’t really matter, so long as the contractors satisfy all of their tax obligations. This couldn’t be further from the truth. Improper classification of workers comes at a high cost, and both federal and state authorities have been cracking down on the practice in recent years.
Advantages of independent contractor status
It’s no surprise why employers prefer to treat workers as independent contractors. If a worker is legitimately treated as a contractor, the employer avoids a variety of financial obligations associated with employees, including withholding federal income taxes, paying the employer’s share of FICA taxes (and withholding the employee’s share), and paying federal unemployment taxes (FUTA).
The employer may also avoid obligations under state law, including withholding state income taxes, paying state unemployment taxes, paying or withholding state disability insurance contributions, and furnishing workers’ compensation insurance. (However, some states may require employers to provide workers’ comp to contractors or pay unemployment tax on amounts paid to contractors in certain situations.) In addition, contractors aren’t entitled to employee benefits, minimum wages, overtime and other rights enjoyed by employees.
Why it matters
There’s a common misconception that the IRS and state tax authorities don’t care about worker classification so long as they’re receiving all the taxes they’re owed. After all, independent contractors are responsible for the taxes that otherwise would be paid by the employer. But the government does care, for several reasons:
- Employers are less likely to default on their tax obligations.
- It’s much easier to collect taxes from a single employer than from many independent contractors.
- Even if all taxes are collected, the government also wants to maximize unemployment contributions.
- The U.S. Department of Labor, state labor departments and other employment security agencies have an interest in expanding the class of workers entitled to employee benefits, wage-and-hour protections, and workers’ comp coverage.
The consequences of misclassification can be harsh. If the IRS determines that contractors should have been classified as employees, it may require the employer to pay back taxes (including the employees’ share of unpaid payroll and income taxes), plus penalties and interest. And if the employer lacks the resources to pay these liabilities, the IRS can collect from “responsible persons,” including certain executives, partners or managers. And keep in mind that federal and state tax authorities can impose penalties on employers who misclassify workers even if all their contractors satisfy their tax obligations.
How to protect yourself
If your business uses independent contractors, conduct an assessment to determine whether they constitute employees under federal and state law. In making this determination, the IRS examines a variety of factors that reflect the level of behavioral and financial control you have over a worker, as well as the nature of your relationship.
For example, workers are more likely to be considered contractors if they control how and when the work is done, cover their own expenses, invest in their own facilities and tools, make their services available to the relevant market, and can realize profits or incur losses. The IRS also considers the parties’ written agreements, any benefits provided to the worker and the permanency of the relationship.
Given the steep price of misclassification, be proactive when it comes to employee vs. contractor status. If you’re concerned about potential liability, discuss options with your tax advisor and consider participating in voluntary classification settlement programs. These programs allow you to resolve these issues with the IRS or other government agencies at the lowest possible cost.