The classification of workers as either employees or independent contractors is one of the most asked questions by small business owners hiring workers. Categorizing employees may seem intuitive, but small-business owners are finding out the reality can be much murkier. This is a hot-button issue with the U.S. Internal Revenue Service (IRS), so experts from the Virginia Society of Certified Public Accountants (VSCPA) want to shed light on this subject to ensure business owners comply with IRS regulations.
The reason worker classifications have caught the attention of the IRS is simple: employers must withhold income taxes, Social Security and Medicare taxes (with required matching), and pay unemployment tax on wages paid to employees. There is no such requirement for independent contractors. It is up to the family business owner to properly classify workers, so it is critical to know what the IRS looks at when it weighs whether one is an employee or independent contractor.
IRS Form SS-8 was created to assist in determining whether enough control is exercised by the family business owner over the worker to be regarded as an employer/employee relationship. The key word in this situation is “control.” The facts that determine how much control is exerted by one party over the other fall into three categories:
- Behavioral: Does the company control how the worker does his job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? How is the worker paid? Are expenses reimbursed and supplies given?
- Type of Relationship: Are there written contracts? Does the worker receive employee-type benefits such as vacation pay, insurance or pension coverage?
This is not, however, a scorecard test. One cannot simply go through the checklist and tally up how many employee answers vs. how many independent contractor answers there were. Rather, it is a relationship test, and certain factors weigh more heavily than others. In most cases, common sense usually points owners in the right direction.
For the business owner, particularly a small family business hiring an employee for the first time, the record keeping, remittance of taxes, and forms filing can be onerous. When coupled with the financial obligations of matching Social Security and Medicare taxes, as well as paying federal and state unemployment tax, the incentive to treat a worker as an independent contractor is enticing. For the worker it is certainly in his or her best interest to have taxes withheld, Social Security and Medicare matched, and to participate in any benefit programs the business may offer. Independent contractors are responsible for their own income taxes and the full amount of Social Security and Medicare taxes.
It is important to get the classification right. The penalties for misclassifying an employee as an independent contractor vary depending on whether the misclassification was willful or not. For honest mistakes, if proper paperwork was filed, the penalty is 1.5 percent of wages paid to the employee, plus 20 percent of the amount that should have been withheld for Social Security and Medicare, plus 100 percent of the employer’s share of Social Security and Medicare. These penalties can go back three years. Penalties get much worse for willful misclassification. Even by the roughest estimates, the penalty isn’t worth the risk of getting caught.
Small business owners must perform their due diligence when hiring and classifying workers. Owners who currently use independent contractors should consider reviewing the nature of their relationship with them. If workers who were classified as contractors appear to be misclassified employees, take steps to rectify the situation. There are relief measures for voluntarily reclassifying these workers. The bottom line is: Don’t guess.