As summer approaches and brings with it many seasonal jobs, it’s probably a good time to revisit a common and potentially costly mistake: misclassifying common-law employees as independent contractors. While hiring independent contractors reduce costs in the short-term, having the IRS or state agency reclassify these workers as employees later can have devastating financial consequences.
A Common, Costly Error:
In 1984 (yes, 1984) the IRS performed its last comprehensive study on worker misclassification and found that 15% of employers misclassified nearly 3.5 million employees as independent contractors, costing the Treasury over $1.6 billion in lost tax revenue. Adjusted for inflation, this equates to roughly $3.5 billion in today’s dollars. The US Treasury believes worker misclassification has become even more common (and costly) over the years. As stated in a 2013 report that urged increased enforcement, “The misclassification of employees as independent contractors is a nationwide problem that continues to grow and contribute to the Tax Gap.” (TIGTA #2013-30-058).
Reasons for Misclassification:
Worker misclassification occurs for a variety of reasons. Sometimes the worker asks to be treated as an independent contractor so they can deduct work-related costs as a sole proprietor on Schedule C. Other times, the position is temporary or employers want to test-the-waters with a new worker before bringing them on as a full-fledged employee. There are also instances in which a business hires a person who is already an employee to perform an additional service such as nightly cleaning. The employee is treated as an independent contractor when performing these other services, avoiding over-time pay for the business.
Much at Stake for Government & Businesses:
Worker misclassification does not just cost the IRS lost tax revenue. It also costs the states, insurance companies, and the misclassified employee: 1) The State Tax Department loses income withholding and income taxes; 2) The Unemployment Department loses unemployment tax; 3) Insurance Companies lose workers compensation premiums; and 4) Misclassified employees lose retirement and health benefits the company may offer employees. They may also discover they do not have medical coverage if hurt on the job.
Worker misclassification also costs businesses, especially those that are following the rules. Businesses that treat employees as independent contractors have lower costs and are able to offer lowers prices for their products and their services. This creates an uneven playing field and makes it very difficult for their rule-following competitors to compete.
Potential Cost of Misclassification: Businesses that misclassify workers put themselves at risk in a number of ways. First, if a worker treated as an independent contractor is later found to have been an employee the business may owe back taxes to a number of government agencies, plus interest and penalties. Second, if a business offers benefits such as insurance, vacation, and retirement and is later determined to have misclassified an employee or group of employees as independent contractors, the business could be held liable for the repayment of those benefits. And finally, if an independent contractor gets hurt and does not have workers compensation, the employing business may be responsible (ask an attorney) for their medical costs, especially if the worker is shown to have employee status after the accident.
Real World Horror:
Here’s a common real-world scenario illustrating how easily worker misclassification can destroy a business and, in this case, a family. Jack is working for Jim, his brother-in-law, in Jim’s construction business. Jack asks Jim to treat him as an independent contractor so he can deduct the costs of his tools and vehicle as a sole proprietor. Jim agrees – the arrangement will also save him thousands in taxes and workers compensation. All goes great for about 18 months until Jack falls off a roof and breaks his back. Jack loses his income, incurs over $30,000 in medical costs, and cannot work for months. Jack sues Jim claiming he was an employee and should have been covered under worker’s compensation. Jack wins. Jim loses his business and livelihood. The families never speak to one another again.
Avoiding the Horror:
To protect your business from the horror of having its independent contractors reclassified as employees, understand the basics of worker classification. Below is a quick rundown of the three Common-Law Factors the IRS uses to make its classification determinations. Although we’ll briefly discuss each factor below, the bottom line is this: The greater the control the business has over the contractor’s activities and finances, the more likely the worker is an employee and not an independent contractor.
IRS Deciding Factors: The Three Common-Law Factors the IRS uses to determine whether a worker (or group of workers) is legitimately in business for them-selves or are in-fact an employee of the business are as follows:
Common-Law Factor 1 – Behavioral Control: When looking at behavioral control, the IRS will want to determine the amount of independence the worker has in the performance of the duties for which they were hired.
Common-Law Factor 2 – Financial Control: This factor considers how much financial independence the worker has: The less independence, the more likely the worker is an employee. The primary determinant here is that of risking financial loss.
Common-Law Factor 3 – Nature of Relationship: The final assessment used to determine whether a worker is an independent contractor or an employee involves assessing whether the worker is legitimately in business for themselves. Some questions asked in this assessment include:
Facts and Circumstances, Not Agreement: A common error businesses make is assuming an agreement between the worker and the business will stand up to scrutiny. Unfortunately, this is not the case. If the common factors listed above reveal an employee-employer relationship, the worker is an employee.
Take Away: There is no single factor that determines whether a worker is an employee or an independent contractor. Instead, the determination is made by weighing the facts and circumstances surrounding each situation. Perhaps the easiest way for a business owner to steer clear of trouble is to view their worker relationships through a lens of prudent scrutiny and common sense. Although there are several defenses to the assertion that a worker is an employee, such the Section 530 Safe Harbor (a topic for another column), it may be best to use the “know-it-when-you-see-it” approach to worker classification. Hiring a contractor who is legitimately in business will be obvious. Purposefully crafting the worker-relationship to shift the common-law factors to the contractor’s side of the scale, however, may be a sign of trouble to come.
Please remember: This or any article does not constitute or replace the advice of a qualified professional. If you would like assistance with a tax or business-related issue, please feel free to call our office at (304) 267-2594.
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