Independent contractor or employee? Key considerations to avoid costly IRS penalties.

One of the most common, and potentially contentious, questions that has come up during my 15 years as an accountant is determining whether someone should be classified as an independent contractor or an employee. On the surface this may seem like an innocuous decision, but an incorrect classification, and the resulting IRS penalties, can be devastating to a business. In this post, we’ll delve deeper into this murky area to help you and your business avoid costly mistakes.

IRS Penalties

Many business owners don’t want to deal with the payroll, paperwork and tax burdens that come with having an employee. As an employer, you must withhold and remit income, Social Security, and Medicare taxes from an employee’s wages. You also must match Social Security and Medicare withholdings, which are an extra 7.65% out of the business’s pocket. On top of that, an employer must also pay Federal Unemployment taxes for each employee. If you are paying an independent contractor, none of these are required to be withheld or paid.

For these reasons, it certainly seems much easier to treat all of your hired help as independent contractors. Be careful though! If you incorrectly classify a worker as an independent contractor, you will incur what the IRS calls Trust Fund Recovery Penalties. These penalties can be assessed against any person “responsible” for collecting and paying withheld income and employment taxes and who “willfully fails” to collect or pay them. A “responsible” person can be more than just the business owner, it can include officers, directors, board members, and other employees. The penalty for failing to withhold and/or remit these taxes is 100% of the amount of tax evaded, not collected, or not accounted for and paid over. Interest also accrues on the unpaid taxes and there is no cap on the amount of penalty that can be assessed.

Now you can see why it is important to appropriately classify someone from the start. How do you ensure you make the appropriate classification? See some tips below.

Employee vs. Independent Contractor Tests

While there is no sure-fire formula, but I'll talk about some key points to consider when determining employee vs. independent contractor per the IRS.

Generally speaking, if you pay someone for a service that they offer to the general public, they are considered an independent contractor. For instance, you hire Joe’s Painting company to paint your office. If you aren’t hiring a company, the biggest factor to consider is the level of independence of the person you hire. Specifically, the IRS states if you can control “what will be done and how it will be done,” the person you hire will be considered an employee. The IRS clarifies that this rule applies even if you have the right to control their work, but give the person freedom of action. What is important is who has the legal right to control the “what” and the “how” it will be done. If you, the person hiring, has that right, then the person you hire is an employee.

Example: Hiring a plumber vs. your niece or nephew to fix a leaking faucet at your business. When you tell the plumber what project you need completed, he or she will determine what they will do to fix it, how to do it and how much they will charge. If you hire your niece or nephew, you will likely tell them what parts to purchase, how to fix the faucet and what you will pay them. The plumber is an independent contractor and your niece or nephew is an employee of your business.

The more independence a person has in the factors below, the more likely it is that the IRS will consider them an independent contractor.

Additional points to consider under the Behavioral test are:

  • Who decides what tools/equipment to use?

  • Who decides what workers to hire or who assists with the work?

  • Where to purchase supplies and services?

  • Who decides the order or sequence of work?

Financial considerations in the relationship are:

  • Does the person you are paying have a significant investment in equipment?

  • Do you reimburse the person for expenses?

  • Is the person available to seek out other opportunities in the market?

  • Are payments made to the person on a regular schedule for the same amount?

Type of Relationship factors to consider are:

  • Is there a written contract explaining the relationship? (Note: The IRS does not have to honor a contract that only states someone is an independent contractor. The substance of the relationship is what matters.)

  • Do you offer the person any fringe benefits?

  • Did you hire the worker for a specific period of time or indefinitely?

  • Does the person provide services that are key to the business?

Unfortunately there isn’t a formula or points system to give you a clear answer in every situation, but hopefully the above points will help guide you in the right direction to ensure you are classifying someone appropriately.

Ask the IRS for Help

While not necessarily a popular option among businesses, you can always have the IRS make the determination for you. You (the business) or the worker can file Form SS-8 and the IRS will determine the classification based on the facts and circumstances provided. While the answer may not be what you want to hear, this eliminates any gray area and ensures you are making the right decision to avoid costly penalties. Don't forget that this form can be filed by either party. Depending on the relationship your business has with the other party, you may be in for an unexpected surprise if they disagree with your classification and decide to file this form with the IRS.

Given the complexity of certain relationships, your business may decide to seek a tax professional’s guidance. Polaris Tax and Business Services is always here to help with your tax planning needs.

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