Security providers, like other businesses in America, may employ two types of workers – employees and independent contractors. While these workers might look and act the same in the work they do, they subject employers to very different federal and state tax and employment laws and regulations. For example, employers must withhold taxes from employee paychecks and pay a portion of other taxes on the employee’s behalf. Employers must also comply with complex and burdensome recordkeeping and reporting requirements for employees. None of these requirements applies to independent contractors, however, because they are self-employed and are responsible for reporting and paying their own taxes. For many employers, the difference between employees and independent contractors provides a significant economic incentive to classify workers as independent contractors. But employers that wrongly classify employees as independent contractors may face significant tax liabilities, including penalties and interest, as well as leave themselves open to claims for benefits, overtime pay and other liabilities.
While an employer makes the initial determination as to whether its workers are employees or independent contractors, a number of federal and state agencies, including the Internal Revenue Service, the U.S. Department of Labor, state tax department and authorities that administer unemployment compensation and worker compensation can all determine if workers have been misclassified. The more workers it has misclassified, the more costly the mistake may be for the employer, who may not only owe taxes and other payments to these agencies, but who may also be liable to these employees for overtime pay and benefits.
What’s the buzz? How do you avoid mistakes?
How do employers avoid making these potential expensive mistakes? Unfortunately, no “bright line” or definitive test exists for classifying workers as either employees or independent contractors and employers must evaluate each worker. Reducing the risk of misclassification is possible by knowing and understanding how federal and state agencies evaluate workers.
The IRS applies a 20-factor test to determine if a worker is an employee or independent contractor, focusing on financial controls, behavioral controls and the relationship between the parties.
Financial controls looks at whether the worker has an effect on financial decisions: Does the worker have a significant investment in tools or other assets? Does the worker incur expenses the employer is not required to reimburse? Does the worker provide services to others in the marketplace or are the worker’s services performed exclusively on the employer’s behalf? Can the worker realize a profit or loss on a job or does the worker get paid no matter what?
Behavioral controls looks at whether the employer has the right to direct and control the manner in which the worker performs the work. Actual control is not important; the right to control is enough, even if the employer doesn’t exercise the right. The more right to control, the higher the likelihood the IRS will classify the worker as an employee. The right to control exists where the employer has the right to tell the employee where to do the work or what tools to use when doing the work. Other elements of control include the employer’s ability to determine what work must be completed and the order in which it is carried out.
The relationship test focuses on the relations between the employer and worker. Is there a written contract stipulating terms and conditions? Does the employer provide benefits such as vacation pay, healthcare or pension benefits, or other benefits typical of employment? Whether the worker earns income from others also comes into play.
Some statutory “safe harbors” may apply. For example, in some cases, a sales person who directs an employer’s entire efforts at residential sales may be still qualify as an independent contractor under the Internal Revenue Code. An employer may encounter significant problems when an employer has both employees and independent contractors doing the same work, however.
Both the Department of Labor and IRS are stepping up enforcement with random audits, and levying financial penalties. States are also getting into the act with new laws penalizing employers for misclassification. The best way to protect yourself from costly potential liability to these agencies and to your workers is to proactively conduct your own employment audit. To encourage businesses to properly classify their workers without worrying about big penalties, the IRS is rolling out a voluntary program. Employers who opt into the program will owe 10 percent of the tax liability that otherwise would have been due on employees’ compensation for the past year, without interest or penalties.
