Understand the Differences Between Contractors and Employees to Avoid Misclassification Penalties

There are many benefits for businesses in hiring contractors, rather than employees, for certain roles. The most obvious may be that you’re not on the hook for payroll taxes or benefits for contractors. That’s not just a cash flow issue. We all know the administrative burdens of reporting and remitting payroll taxes and managing employee benefit programs. In the age of the gig economy, many workers also prefer the flexibility of contract arrangements to the constraints that come with full-time employment.

But a person isn’t a contractor just because both parties have agreed that they are. If you have (or plan to have) contractors as a regular part of your labor model, you want to make sure the IRS will agree with your classification of workers as contractors and not as employees.

Of course, the IRS doesn’t have a clear-cut definition by which to judge who is a contractor. That’s good news to the extent that you have some flexibility in structuring your contractor relationships. The bad news is that the classification can be highly subjective. It may require you to either roll the dice with the IRS or seek advice from outside your organization.

While there is no single fact that places someone definitively in either category, we have highlighted some of the most relevant distinctions in our infographic. We caution business owners that the IRS would evaluate the entire relationship in making their determination, and we encourage you to do so, as well.

The penalties for classifying an employee as a contractor, with no reasonable basis for doing so, can include back payment for the company’s portion of payroll taxes related to the employee’s wages, as well as the employee’s share.

How can you prevent misclassification of your workers?

  1. Document the factors you’ve used in determining that someone is a contractor. In the event the IRS disagrees with you, this will at least provide evidence that you had a reasonable basis for believing your classification was correct.
  2. If you have a vendor services agreement with the contractor, be sure you are not violating any of the terms. For example, the agreement may state that expenses incurred by the contractor are the contractor’s responsibility. Do not permit him or her to submit expense reports for reimbursement in the same manner as your employees.
  3. Insist that contractors submit itemized invoices for payments due. Only pay upon receipt of the invoice. Recurring payments with no supporting invoices simulate a salary, which indicates status as an employee.
  4. Seek an official IRS determination. You can file Form SS-8 with the IRS. They’ll tell you how to classify the worker. Note that it can take six months to receive this ruling. So, if you need a quick decision, you may prefer to seek advice elsewhere. If you are planning to hire many contractors who will be doing the same kind of work and you need a ruling that can be applied to all of them, filing Form SS-8 is recommended.

If you’d like to discuss the classification of your contractors and employees and how you can structure the most advantageous labor model for your business, contact 9Gauge today. For more information on our financial advisory services (FAS), click here.