Independent contractors: Classify them correctly or pay the price

For many years now, the IRS has been monitoring and often challenging employers’ handling of independent contractors. The agency contends that some companies are misclassifying employees as independent contractors.

With the passage of the Affordable Care Act, there may be increased incidences of employees being classified as independent contractors, especially among construction companies and other project-driven businesses.

There may also be increased monitoring. Construction companies are particularly in danger of running into classification troubles with the IRS, so learn how to accurately distinguish between the two categories – and what to do in case a misclassification occurs.

The IRS is Watching

The IRS has gone as far as to launch a formal national research project to study independent contractor use, fringe benefits and other related payroll issues.

And construction companies – with their various subcontractor and project-specific, specialist relationships – are particularly in danger of running into classification troubles.

Paying the Taxes

As you probably realize, as an employer, one of the major differences between a conventional employee and an independent contractor involves taxes.

Payments remitted by an employer to their independent contractors aren’t subject to withholding of payroll or income taxes, and you don’t have to pay the employer share of FICA or Medicare taxes.

As an employer, you also aren’t subject to unemployment or workers’ compensation insurance requirements for independent contractors.

Why is the IRS paying such close attention to the use of independent contractors?

Worker misclassification diminishes federal income revenue by billions of dollars annually, the IRS says. Naturally, states also lose tax dollars, and many are taking action. As a result, New York passed the NYS Construction Industry Fair Play Act in August 2010.

Making the Distinction

In a recent case, Mieczyslaw Kurek, Petitioner v. Commissioner Of Internal Revenue, Respondent Docket No. 5459-11, Feb. 28, 2013, the owner of a construction company was liable for employment taxes for certain workers that he hired to complete construction projects.

The workers were determined to be employees rather than independent contractors based on the application of the common law principles for making an employment relationship determination.

None of the workers worked full-time for the owner. There was evidence that the owner and one of the workers believed they had created an independent contractor relationship. These factors were outweighed because, based on the evidence:

  • The owner exercised control over the workers in completing the work that they had been hired to do
  • The owner provided the workers with all the heavy tools needed
  • The workers received a negotiated fee from the owner which was not subject to whether or not the project they were working on realized a profit or suffered a loss
  • The owner had the right to discharge the workers at will
  • The workers were an essential part of the owner’s construction operation

As the Kurek case illustrates, the IRS typically looks at three general categories when scrutinizing a company’s independent contractor arrangements:

1) Behavioral control: Basically, this refers to the behavior impacting when, where and how a job gets done. If you direct the work – meaning you require the individual to perform the work on your job site or at your office, at a set time and according to your processes or on your equipment – that person is more likely to be classified as an employee by the IRS. If you define only the outcome of the work and the worker is free to achieve that outcome as he or she sees fit, the individual probably is an independent contractor.

2) Financial control: This refers to control of the financial aspects of the work being done. Here, the IRS examines how much an individual controls financial aspects of his or her work. For example, if a worker has ongoing expenses that aren’t reimbursable (such as investments in facilities, tools or equipment), can market his or her services to others, and is in a position to experience a profit or loss on a particular project, the person likely is an independent contractor.

3) Relationship between the parties: This category considers how the business relationship is structured. Independent contractor arrangements typically include a contract for a particular timeframe and a specific outcome for a set fee. Conversely, employees generally handle a broader array of duties and may be paid benefits in addition to wages or salary.

Correcting the Mistake

If a chance exists that you have misclassified an employee as an independent contractor, don’t panic. Remedies do exist.

You can also review Section 530 of the Revenue Act of 1978 for relief of employment tax liability for worker misclassification. Under it, you may escape penalties if you can show you had a reasonable basis for classifying the worker as you did, treated the worker and all similar workers as independent contractors, and filed Form 1099-MISC for the worker.

There is also a voluntary classification settlement program to help reduce tax liabilities and potential penalties.

Remaining Vigilant

You may have grown comfortable with your handling of subcontractors or other short-term specialists who work on your job sites or in your office.

But vigilance is critical: Any long-term project or a key technicality in the arrangement could draw IRS attention.

If you’re concerned that some of your independent contractors could be reclassified as employees – or you’re not sure whether a new worker qualifies as an independent contractor or should be treated as an employee – your tax adviser can help you assess the situation.