Is your contractor really your employee? Are you potentially facing big problems from an IRS audit?
Worker misclassification is a big problem for businesses who use independent contractors, especially in the construction industry. Improperly classifying employees as contractors are a huge drain on tax revenues. The IRS estimates that $72 billion in employment taxes (that’s with a large B!) are lost each year from improper classification, failure to withhold taxes and other schemes. So you know the IRS is going to be on the look out for potential worker misclassification during an employment tax audit.
So why would an employer choose to classify employees as contractors? Misclassification can save an employer a lot of money in overtime, employee benefits, workers’ compensation, and employment taxes. Employers who don’t play by the rules can push their costs down on to the contractors while underbidding their competition. Improper classification just doesn’t cost the government money it also negatively impacts other businesses that follow the rules.
My purpose is writing this post is to provide some of the warning signs that you may have a problem with your independent contractors.
How the IRS determines who is an “employee.”
Under the IRS’ “common law” test, a worker is an employee where the company has the right to control how the worker performs his or her work (whether it is direct control or economic control). The IRS is going to look at factors which provide evidence regarding the degree of control exercised by the company. These factors can be divided into three categories:
- Behavioral control: how much control does the company exercise over the worker and how he or she does her job? Does the company provide training to the worker? Does the company have a say on how a worker performs his or her work? Is the worker required to be at the company’s place of work and at a set time
- Financial control: does the company exercise control over the worker’s “business?” Does the company provide all of the worker’s tool and equipment; does the company regularly pay the worker; and , does the company reimburse most if not all of the worker’s out-of-pocket expenses?
- Type of Relationship: how does the company and worker view their relationship? Is there a written contract? Is this an indefinite arrangement between the parties or is it for a specific task or time? Does the worker perform key activities of the business and which would normally be assigned to an employee.
What becomes fairly obvious in short order is that labels do not matter meaning that a written contract is not going to make someone who is an employee an independent contractor. Control is the key, whether it is control of how work is performed or control over the relationship between the company and the worker. So what are some warning signs that your company may have a misclassification problem?
The Seven Warning Signs or “Houston we have a problem.”
When you look at the common law test and distill it down, there are seven signs that your company may have a problem:
- Do you set the contractor’s hours? Do you tell the contractor where to be and when?
- Do you provide the contractor with his or her tools and equipment?
- Do you pay the contractor weekly? Bi-weekly?
- Does the contractor work with you exclusively?
- Does the contractor get paid weekly? Bi-weekly?
- Has the contractor worked with your company for a long time?
- Does the contractor perform work normally done by employees of your company?
If one of these applies than you might be ok but two or more of these warning signs indicates a problem that needs to be addressed. If the IRS audits your company and reclassifies your contractors as employees you are facing a huge tax bill potentially. What’s worse is that you and any other owners may be personally liable for a portion of any payroll taxes due. The issue of trust fund taxes is complicated and I don’t want to get too far afield but I do want to make it clear that payroll tax liabilities are big trouble for a business if not paid.
* This list is adapted from the good folks at SCORE (Senior Corps of Retired Executives). Here is the link to SCORE’s article: 7 Clues Your Independent Contractor is Really an Employee … Under the Law
Summary
Running a business is a risky proposition and so if you hire independent contractors to perform work for your company then you also take on the risk of potential problems with the IRS. Consider the 7 warning signs above when you review your current and potential contractor agreements.
There are things that can be done to correct any mistakes but you should take action now rather than wait. In an upcoming post I will talk about the various relief provisions available if you do indeed misclassify a worker.
If you have any questions about what I have written or would like to know more about how a Maine tax attorney can help you deal with an IRS or Maine Revenue employment tax audit than please give me a call at 207-299-0515 or email me using my contact form.
Image courtesy of the Library of Congress.