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Employee or contractor? IRS issues 3 classification tips

by September 15, 2010 2 Comments

business-team

The feds have come out swinging. The Internal Revenue Service is conducting random audits to uncover employee misclassification — and if your company’s found guilty, it’ll face penalties.

The problem: It’s so tempting to classify someone as an independent contractor — and save on federal, state and local taxes, as well as overtime and workers’ comp — if the person’s status as a worker seems fuzzy.

To help ensure companies get classifications correct — and proper tax payments end up in Washington — the IRS recently released a document offering businesses tips on classifying workers.

Here are three critical points businesses need to know.

No. 1 – The IRS uses three characteristics to determine the relationship between businesses and workers:

  • Behavioral control. If the business has the right to control or direct not only what’s to be done, but how it gets done, then the worker is most likely an employee. But if the worker controls the means and methods of accomplishing a specific result, then he or she could qualify as an independent contractor.
  • Financial control. The IRS wants to see whether the company has the right to direct or control the financial and business aspects of a person’s job. If the person has a significant investment in the work, or the person isn’t reimbursed for some or all business expenses, he or she may be an independent contractor. Also, if the person can earn a profit or incur a loss, it’s an indication the person’s in business for him or herself and is an independent contractor.
  • Type of relationship. The IRS will also look at how the worker and the business owner perceive the relationship. If the person receives benefits, such as insurance, pension or paid leave, this is an indication that the person’s an employee.

No. 2 — Both businesses and workers can ask the IRS to make a determination on an individual’s employment status by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

No. 3 — Additional information to help with determining a worker’s classification can be found in the IRS’ Small Business and Self-Employed Tax Center on its website. Other resources available include:

Categories: Employment Law, Management, Pay and Benefits
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  • Joanne

    I’m in NH and not sure of others state but also be careful that you are meeting the laws in your own state even if the contractor definition applies federally. In NH Unemployment statute there is a 3 prong ABC test in which all of the prongs must be meant and is stricter than other ABC tests. There is a huge misconception that if the employee and employer agree, even in writing that an independent contractor you are. This has proven true countless times resulted in back unemployment taxes. The old saying, never assume, is quite true.

  • Iain Climie

    There have been similar concerns in Britain related to legislation known as IR35. This attempted to class certain contractors (often those who have worked somewhere for a considerable time) as “disguised employees” who would then have to pay more National Insurance than otherwise. There is an organisation called the PCG (Professional Contractors Group) over here which was set up largely in response to this – see http://www.pcg.org.uk.

    Obviously there are massive differences in tax approaches between the UK and US but there may still be some worthwhile information or potential lessons from this side of the pond.