It is important that businesses properly classify their workers. Businesses can be subject to back taxes, interest and penalties if they treat someone as an employee yet pay them as an independent contractor.
Businesses cannot simply pick which option they like better as they are not equivalent choices. What the business controls, the financial investment of each party and the relationship the business has with the worker will point to either an employer-employee relationship or a business-contractor relationship.
Independent contractors are self-employed
An independent contractor is someone who is self-employed and operates their business independently of the business who has hired them. Businesses hire independent contractors to do a specific task or a set of tasks for a period of time. Their work is typically unrelated to the hiring businesses core activities. Employees are not self-employed and have an important, ongoing role in the operations of the business.
Here are a few examples of workers who fall under the category of independent contractor:
A business could hire an accountant, attorney, maintenance or repair personnel to be on staff and pay them as employees as well. The example of the accountant will be used below to highlight how the IRS guidance applies to an employee vs. independent contractor classification.
Why proper worker classification is important
The government prefers workers be classified as employees. Classifying a worker as an employee subjects the hiring business to more rules and laws and requires the employer to pay additional taxes. Therefore, a business won't be penalized for classifying a worker as an employee since that is the government preference.
If there are independent contractors working for your business, it's best to be absolutely certain that "independent contrator" is an appropriate classification. The U.S. Department of Labor website explains why the government takes this so seriously. Both federal and state governments seek out business owners who might be misclassifying workers.
"Employee misclassification generates substantial losses to the federal government and state governments in the form of lower tax revenues, as well as to state unemployment insurance and workers’ compensation funds." U.S. Department of Labor
Federal and state governments have been known to target businesses with substantial payments to independent contractors to audit them.
Some workers may prefer to be classified as independent contractors because employees are not permitted to deduct unreimbursed employment expenses on their personal tax returns. Whereas independent contractors can claim business deductions. However, worker preference is not a factor in the classification determination.
IRS guidance and state laws
The IRS provides guidance on employees vs. independent contractor classification but your state may have rules that are more strict so be sure to consult your state government websites. It is also a good idea to consult a business or employment attorney if you plan to classify any regular, ongoing workers as independent contractors.
For example, in CA the first question to ask in determining whether a person can be an independent contractor is what is industry. Certain industries fall under the "ABC test" and others fall under the "Borello test." Under more restrictive ABC test, a person is an employee unless they can show A) the business does not control or direct the work, B) the work being done has no relation to the core business activities, and C) the independent contractor has their own clearly established independent business. See LA Times article, California’s top court makes it more difficult for employers to classify workers as independent contractors and CA Assembly Bill No 5, Section 621(b). Licensed psychologists, physicians, dentists, podiatrists, veterinarians, attorneys, architects, engineers, private investigators and accountants, and additional industries that were added in a law change in September 2020, are subject to a less restrictive test known as Borello. The Borello test does not guarantee the worker can be an independent contractor. Under Borello, a worker may be considered an employee.
California is not the only state with strict rules. Wisconsin has a Nine requirements test to determine if a worker can be appropriately classified as an independent contractor. These factors include showing the independent contractor maintains a separate office space, receives payment for each contract, job or bid and has ongoing expenses such as rent, payroll and insurance.
If your state has more strict rules, follow the rules of your state. If your state does not have strict rules, follow the guidance from the IRS. In other words, if there is any way for either the IRS government or state government to find your worker is an employee, it is best to classify your worker as an employee.
Control (employee) vs. Independence (contractor)
This section covers IRS guidance to help business owners determine if their worker is an independent contractor or an employee. No single factor outweighs all the others. Look at all factors together and consider the totality of them. Only classify a worker as an independent contractor if overall you can justify how and why this worker is not an employee.
The IRS looks at three categories: behavioral control, financial control and relationship:
It does not matter whether the business exercises control over the worker, it matters if they have the ability to exercise control. The IRS considers training the worker how to do the job to be strong evidence of employee status. The consider periodic or ongoing training about procedures and methods as very strong evidence of employee status. An independent contractor get their own training because they are self-employed working for many clients or customers, not one employer.
The following factors indicate an employee vs. independent contractor level of behavioral control:
Using the example of an accountant, if you hire an accountant as an employee you are likely to direct what they will work on, provide a permanent workspace, determine if they need an assistant, provide training on your business operations or require attendance at regular meetings. If you hire an accountant as an independent contractor, you will agree on what reports or tax returns the accountant will deliver and you may provide them with a temporary workspace if they come to your office, but they also have their own office, their own internal business meetings and they will not be part of your ongoing meetings or training.
Consider how much right the worker has to control the economic aspects of their job. Independent contractors are self-employed so they have business risk. They have to generate enough revenue to cover expenses to avoid a loss. Whereas, employees are usually paid a relatively predictable or consistent amount and don't incur the kind of expenses that could result in a loss because they are not operating a business.
The following factors indicate an employee vs. independent contractor level of financial control:
With our accountant example, an employee accountant will have regular a regular schedule and regular pay, will be provided a phone number, email address, supplies and may get reimbursed for any expenses. On the other hand, an outside accountant hired as an independent contractor may be working for many businesses at once, will have their own website and marketing, provide their own supplies and will be paid only when they deliver agreed upon reports and returns.
The relationship between the business and the worker are reflected by written contracts, presence of employee benefits, permanency of the relationship and type of services. Independent contractors usually perform services that are not related to the key operations of the business, they work on a specific project or for a specific period of time and usually do not receive benefits.
The following factors indicate an employee vs. independent contractor type of relationship:
If your business hires an accountant to work as an employee there may be a contract that limits their ability to work for others at the same time, may offer benefits such as earning paid time off and have no specified end date for their work. Conversely, a contract with an outside accountant will usually specify services for a certain task or time period, no benefits, no limits on who else the accountant can contract with and specify they will be paid a set amount when they deliver the reports or returns.
Whether the work is part of the core business activities is a determining factor in some states like California, for the IRS it is only one factor. Therefore, in California an accounting firm hiring an accountant to work for clients is appropriately classified as an employee. Elsewhere, an accountant may be able to work for an accounting firm and be an independent contractor depending on other factors. For a non-accounting firm such as a therapy private practice, coaching business, or small legal firm, an accountant could be an employee or an independent contractor.
If a business is found to have classified a worker as an independent contractor when they were really an employee, the IRS will determine if you had a reasonable basis to do so. If the business had a reasonable basis, they may eligible for relief from paying the back employment taxes. If there is no reasonable basis for having treated the worker as an independent contractor, the business can be held liable to pay employment taxes for past years and going forward.
If a new owner takes over a business from someone else, there is potential the new owner could be liable for the predecessors tax burden if workers have been misclassified. Investigate if workers have been properly classified before purchasing or assuming responsibility for an existing business.
Ask the IRS
If you have read the IRS guidance and cannot decide whether the worker is an independent contrator or an employee, you may fill out the IRS Form SS-8: Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. Based on information you provide, the IRS will make a determination for you. It may take six months to get an answer, but it is better than finding out years later during an audit.
Either the worker or the business owner can file Form SS-8 to get a determination. Workers can also file Form 8919: Uncollected Social Security and Medicare Tax on Wages if they believe they were an employee and were misclassified as an independent contractor.
If a business realizes they have misclassified their employees they can report themselves under the Voluntary Classification Settlement Program (VCSP). Employers file Form 8952, Application for Voluntary Classification Settlement Program (VCSP). Eligible employers may be able to get relief for past employment taxes and pay only 10% of the current employment tax liability by agreeing to change their worker classification and pay all future employment taxes.
Your state may also have resources to help you with making a determination.
If you are concerned about worker classification and have in the past or intend to classify future workers as independent contractors, it is best to consult a business or employment attorney. Retain documentation to support your conclusion.
You can treat anyone working for you as an employee and it will not concern the IRS or your state government as long as you follow the employment rules and laws, and pay all employment taxes due. If you want to treat workers as independent contractors, review the rules and get professional advice to ensure the classification of independent contractor is supportable under both the IRS and your state laws.
Questions: email [email protected]
Jennie Schottmiller, LMFT, CPA is a licensed marriage and family therapist who practiced as a CPA prior to becoming a therapist. She has an active solo therapy practice and offers courses to help small business owners with accounting, tax and financial analysis matters.
Disclaimer: This blog is for education only. Please consult with a qualified professional when you have any questions about your personal accounting, tax or legal situation. Information contained in this post is for informational purposes only and not intended to replace professional advice.