One of the most common and potentially costly mistakes business owners and their managers can make is that of misclassifying workers—misclassifying employees as independent contractor. While in the short-term, this may save the business money in terms of taxes and benefits, repaying these taxes and benefits once a worker (or class of workers) has been reclassified by the IRS or state agency as an employee can literally sink a small business.

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.  This may not seem like a lot, but it was estimated that those errors cost the Treasury over $1.6 billion in lost tax revenue.  Adjusted for inflation, this equates to roughly $3.5 billion in today’s dollars.  Although the IRS is currently conducting a new worker misclassification study, there is little optimism that the misclassification rate has dropped over the past 40 years.  It is this belief that caused the Treasury Inspector General to urge the IRS to step-up employee misclassification enforcement efforts in a recent report (TIGTA #2013-30-058). 

Reasons for the Error:

Worker misclassification occurs for a variety of reasons. Sometimes the worker asks to be classified as an independent contractor so they can deduct work-related costs as a sole proprietor on their 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 organizations hire 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 so the company can avoid paying over-time.

One of the most common reasons for worker misclassification, however, is in response to the rising cost of doing business.  Businesses that face rising tax and employee benefit costs will often look to outsource certain services.  By hiring independent contractors rather than employees, they can reduce their costs and remain competitive. 

Independent Contractors and the Affordable Care Act:

A flurry of cost-driven outsourcing is anticipated as the Affordable Care Act’s employer mandate requires those with more than 50 full-time-equivalent (Note: This is not the same as 50 full-time) employees to provide health insurance to their employees.  Although this requirement was delayed for a year, there is a growing uncertainty as to how high insurance premiums will climb prior to the employer mandate kicking in.  This uncertainty will undoubtedly cause many businesses to consider hiring independent contractors as opposed to employees.

Much at Stake for Government & Businesses:

Businesses often make the mistake of thinking that only the IRS has incentive to challenge the status of an independent contractor.  This, however, is far from the truth.  Worker misclassification also costs the states, insurance companies, and the 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. 

The costs of worker misclassification do not stop with lost taxes for the government.  Businesses can also put themselves in grave risk of financial calamity when they misclassify an employee as an independent contractor.  First, if a business owner is later found to have misclassified an employee, or worse – a group of employees, they may owe back taxes to all 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 all those benefits to the workers.  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 worker misclassification can destroy a business, and 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 workers 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: One of the most common errors businesses and workers make is believing an agreement between the worker and the business will stand up to IRS scrutiny.  Unfortunately, this is not the case.  If the common factors listed above reveal an employee-employer relationship, the workers are employees.
 
Take Away: There is no single factor that will determine 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 as what is called the Section 530 Safe Harbor (a topic for another column), a business can avoid the issue altogether by using the “know-it-when-you-see-it” approach to their worker relationships.  If you are hiring a contractor that is legitimately in business, it will be obvious.  If, on the other hand, you find yourself crafting the relationship (and the worker) to weigh the factors above on the contractor’s side of the scale, you may be setting yourself up for trouble. 

Please remember: This or any article does not constitute or replace the advice of a qualified professional.  If you would like assistance with taxes, books, or determining worker status, please feel free to call our office at (304) 267-2594.

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