By: Bethany Knittel
Channel Marketing Manager
More than 10 percent of employers misclassify at least one worker as an independent contractor according to numerous state-level studies. Unlike strong quarterly financial reports, misclassifying a worker is never good news.
Being adequately informed about the impactful differences between an employee and an independent contractor from a tax filing and compliance perspective can mean the difference between compliantly savvy or unlawfully expensive. With classification confusion and ever-changing employment laws, it is more crucial now than ever for employers to correctly classify their workforce for optimal compliance and efficiency.
What’s in a Name?
Correctly classifying workers begins with revealing the various layers of classification as defined by the IRS. These layers are often referred to as The Common Laws Rules and encompass three key aspects: financial control, behavioral control, and the state of the relationship. By understanding these Common Law Rules, companies and workers alike can move ahead confidently in their professional pursuits equipped with the ability to differentiate between an employee and an independent contractor.
The first of the three Common Law Rules is financial control. Under the lens of financial control, an employee is generally defined as “a worker with whom a company must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid.” Often, at the end of the fiscal year, employees receive a W-2 tax form, whereas an independent contractor would receive a 1099 tax form. For independent contractors, companies are not responsible for withholding taxes and usually pay the contractor when the work is complete. When it comes to filing, companies are not involved in the tax withholding process when working with an independent contractor.
The next Common Law Rule revolves around how the work is done, otherwise known as the behavioral control of the worker. Often, workers classified as employees are trained in the work and are required to adhere to instructions set by the hiring company. Being at a particular location, adhering to a dress code, and using specific work tools are just a few examples of behavioral control over an employee. The more specific and plentiful the instructions are, the more likely the worker is an employee. When it comes to evaluating the work, employees are often assessed on the process of how the work is completed.
In contrast, independent contractors are evaluated on the final product of the work itself. An independent contractor often does not need to be trained but is a subject matter expert using their methods to accomplish and carry out tasks. Independent contractors often work with tools that they own and are more concerned with delivering the final product of their work.
The third and final way a worker can be classified using the Common Law Rule is by observing the type of relationship present between the company and the worker. The elements that especially highlight the relationship are often regarding written contracts, benefits offerings, the longevity of the interaction, and the level of importance of the work is being done.
It is most common for an employer-employee relationship to exist if benefits such as paid time off, paid leave, pension plans, and disability insurance are provided. When it comes to written contracts, they are often mistaken as indisputable law. It is the interaction between the company and the worker that dictates the classification of the worker.
Another factor impacting the relationship is the longevity or permanence of the interaction. If a worker is to remain with the company for an indefinite period, this can indicate that the worker is an employee; whereas a defined period usually suggests the worker is an independent contractor.
The Impact of Improper Classification
It is important to correctly classify these two labor types because it can be extremely costly, from both a financial and a resource perspective, to misclassify them. According to netPolarity, failing to provide W-2s to employees can result in back taxes up to forty-one percent of the employees’ wages and can go back for three years.
Intentional or fraudulent misclassification of a worker can result in much heftier fees. If the IRS believes a company deliberately misclassified workers to avoid paying taxes and withholding wages, the IRS can charge criminal penalties of $1,000 and up to 1-year imprisonment. If the IRS obtains a felony conviction against a person or company convicted of tax evasion, fines can amount to $100,000 ($500,000 for corporations), or imprisonment up to 5 years, or both in addition to the cost of prosecution.
If there is any doubt about whether a worker is an employee or an independent contractor, the IRS has a nifty form called an SS-8 to help determine that.
Properly classifying workers does not have to be stressful. Guidelines have been put in place to ensure that workers and companies alike can sail smoothly in the waters of compliance with the right knowledge and support. By reviewing the Common Law Rules set by the IRS of financial control, behavioral control, and the relationship, companies can adequately determine whether their workers are independent contractors or employees.