March, 2010 Tax Newsletter

Important to Distinguish Between Independent Contractor and Employee

The IRS and most states are cracking down on companies that try to trim payroll costs by changing employee status to that of independent contractor.  This costs the Treasury billions of dollars and can leave workers high and dry when they are hurt at work or left jobless.  This has been especially true during the economic downturn.  By classifying workers as independent contractors, businesses can save as much as 30% of payroll by avoiding unemployment insurance and workers’ compensation payments as well as the employer’s share of payroll taxes.  Many workers would also prefer to be treated as independent contractors because they do not have payroll taxes deducted from each paycheck and more of their business expenses are tax deductible.

While both you and the contractor may benefit financially from this arrangement, your choice is limited by law.  If you misclassify a worker, you should be prepared to face penalties and back taxes for the employee and employer’s share of Social Security, Medicare, and unemployment taxes, as well as federal and state income taxes.  To determine employee status the IRS looks at  “who controls the worker” .   It  analyzes three  elements:   behavioral control, nature of the relationship, and the financial arrangement between the parties.  The courts have applied a 20 factor test in determining the issue of control, with appropriate weight given to the various factors depending upon their perceived relevance in a given case.

In general, behavioral  control deals with matters involving the worker’s performance, such as who  controls  the work hours and location, the order of sequence of the work process, and the party owing the tools or equipment used to get the job done.  Nature of the relationship looks at the permanency  of the relationship if the work performed is a critical and regular part of the business, whether there is a written contract, and if the worker is responsible for his/her own benefits.  Financial control examines areas including whether the worker has a significant investment (such as owing his own tools) and his  ability to make his services available to others.

This is a complex tax area which also involves the Department of Labor.   In the past several years the IRS and state authorities have devoted many resources to stem the perceived abuses.  As mentioned, they intend to devote even more resources to weeding out the persons who are misclassifying their workers.  Because this area is fraught with danger, it is highly advisable to consult with your attorney or tax advisor if you plan on using independent contractors in addition to, or in lieu of, full-time employees.