It has been over 25 years since the IRS conducted an extensive audit of employment tax issues. Over the next three years, however, the IRS will audit approximately 6,000 randomly-selected companies, varying in size and industry. One of the main issues to be examined in these audits is worker classification.
Generally, the IRS favors classifying workers as employees and only permits independent contractor classifications in clear circumstances. This is because a company does not pay employment taxes or withhold income taxes when workers are classified as independent contractors. The independent contractor pays the full amount of employment taxes and, typically through estimated payments, pays income taxes. Further, independent contractors are not entitled to company-offered unemployment, retirement and health benefits. Nor are they eligible for several federal protections available to employees. As such, misclassification hinders the ability of the IRS to collect taxes that should have otherwise been paid. Misclassification also prevents workers from participating in employee benefit plans and from receiving all of the legal protections to which employees are entitled.
To establish an independent contractor classification, the IRS requires that the hiring company illustrate a lack of control over the worker, thereby nullifying the existence of an employer-employee association. Generally, the relationship of employer and employee exists when the hiring company has the right to control and direct the worker, not only as to the result to be accomplished by the worker but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done but as to how it shall be done. It is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if the employer has the right to do so.
To help determine whether an individual is an employee, the IRS considers numerous factors indicating whether sufficient control by the hiring company is present. These factors fall into three general categories:
1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does her job;
2. Financial: Are the business aspects of the worker’s job controlled by the company (for example, how is the worker paid, are expenses reimbursed, who provides the tools and supplies?); and
3. Relationship: Are there written contracts or employee-type benefits (for example, is there a pension plan, insurance, or vacation pay?)
The degree of importance of each factor varies depending on the occupation and the factual context in which the services are performed. None of the factors are singularly determinative and all factors should be considered in making an accurate determination.
The various state revenue and labor departments are also concerned with worker misclassification. The worker classification analysis used by many states may differ from the factor test utilized by the IRS, possibly resulting in different classifications based on the same facts.
If your company utilizes independent contractors and you have worker classification questions, either at the federal or state level, you should consider contacting an attorney to discuss your particular circumstances.