Truth or Consequences: When is an outside contractor really an employee?

A list of withholding taxes from the pay stuffMany small businesses legitimately outsource work to outside contractors and consultants. Doing so is one of the ways that small businesses can be flexible and cost effective about getting the services they need without taking on the overhead of full time employees. It’s also an area of great confusion for business owners.

But businesses that utilize independent contractors should heed the recent IRS warnings about misclassifying employees as outside contractors when the facts indicate that they actually fall within the guidelines of an employee relationship. In addition to being responsible for paying back payroll taxes, the IRS has indicated that the company could be subject to fines and penalties.
The IRS has also indicated that employee misclassification could lead to an audit which would then open the door to visits from other agencies such as the Department of Labor. Because most businesses don’t intentionally misclassify the employee/contractor relationship, they are often the most surprised when their seemingly legitimate actions lead to these unintended consequences.

The Burden of Proof is on the Business

The onus is on the business to make the proper determination of the relationship status of any individual who performs services for pay. The guidelines for making that determination are based on a set of Common Law Rules that provide a measure of the amount of control and independence that exists between the individual and the business. The basics are as follows:

  • The first rule centers on the measure of behavioral control a business exerts over how the individual conducts his work. If a business can dictate the hours of work or the way a job is completed, it may be acting in the capacity of an employer.
  • Another measure is the structure of the financial relationship. When the business controls the financial aspects of the relationship, such as how and when a worker is compensated, it is acting more like an employer.
  • Then there is the business relationship test. For instance, are there employee benefits provided and are the services a key activity of the business?

Also considered are the duration and the necessity of the relationship. And sometimes the status can change. The services provided by workers who were properly classified as outside contractors initially may evolve in ways that can change their status to employee. Applying an interpretation of the “rules” can be murky, as job descriptions and worker responsibilities vary widely. But it is important to understand what is involved so that there aren’t unanticipated financial consequences.

Making the Case

While these are all determining factors when classifying an individual, they must be considered collectively in order to make a proper classification. It may be that, in a given situation, not all of the factors are pertinent. And it is possible that the measure of these factors could be divided equally between a classification as an employee or a contractor. In all questionable situations, it is important to weigh each factor in terms of the amount of control that is exerted in each area make a case for the classification.

Being Proactive

Businesses that routinely work with independent contractors should establish a contractor relationship template based on the IRS guidelines and adhere to it when managing all contractor relationships. Detailing how to evaluate the job requirements along with the supervisory and compensation relationships will help you to make decisions as you go along.
Most importantly, don’t simply classify everyone as an independent contractor to save on payroll taxes or benefits payments. Make individual determinations based on an understanding of the rules and the nature of the job requirements so that if there is ever a question, you can back up your decision with facts.
In most instances, you, your accountant or an employment lawyer you can make a reasonable determination. But if you are unsure, you can get a determination from the IRS by filing Form SS-8, Determination of Worker Status, This can take quite some time to get an answer, so it’s not going to help you with your initial determination. Along with its determination, the IRS will inform you of any taxes owed in the case of a mis-classification.

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