In order to succeed, most companies – large or small – need the help of additional individuals in a variety of roles who will help the company achieve its mission. Depending on the details of the arrangement in the work that these individuals do for a company will lead them to be considered either an independent contractor or an employee.
In a vacuum, most companies would rather have independent contractors. There are no Social Security or Medicare taxes paid by a company on payments to an independent contractor, and there is no workers’ compensation insurance or unemployment taxes, either. The contractor – in business for himself or herself – takes care of these taxes and insurance themselves through their own companies.
The IRS lays out a number of characteristics of contractors vs. employees, which provides a good guideline for companies in doubt of the status of the working relationship. Basically, it comes down to supervision, direction, and control of the services of the worker. If the company supervises, directs and controls the work, the worker is an employee. If the contractor has the autonomy, he is an independent contractor. Simply providing a 1099-MISC to a worker does not make them a contractor; the nature of the work arrangement dictates the status of the worker.
The IRS, and more appropriately, the Department of Labor (DOL), would prefer for the workers to be classified as employees. The DOL looks to protect workers and making sure that workers are not paying additional Social Security, Medicare and unemployment taxes is under their auspices.
Occasionally, an IRS or DOL audit will unearth workers who are incorrectly classified, but another event that will trigger an investigation is if a company has a worker who files an unemployment claim. Let’s look at an example.
Company A treats Worker B as an independent contractor for a short-term engagement. After this engagement, Worker B is no longer working and believes himself to be subject to unemployment compensation and files the appropriate paperwork. When the state unemployment department reviews Worker B’s claim, they will notice that Company A never treated Worker B as an employee. The department will then interview Worker B to see why he believes himself to have been an employee.
Often, the department will default to Worker B’s responses, and if those responses show that Worker B is an employee, the department will contact Company A and let them know that they classified Worker B improperly. They will also ask for amended quarterly payroll tax returns, with interest and penalties attached. Because this process often takes many months, it is possible that interest and penalties will have accrued for a year or more.
In order to avoid a situation like the example above, companies need to be sure that they are correctly and consistently applying contractor vs. employee statutes to each of their workers as well as maintaining detailed documentation about why workers treated as independent contractors are viewed as such.
By Dan Massey, CPA, Manager