Employee vs Independent Contractor – A Big Issue for Small Business

The IRS exists in part to collect taxes. Because they cannot audit, or look over the shoulders of every taxpayer, since their inception their behavior has been one that puts them at odds with taxpayers, in particular, business owners. The premise is simple: Scare folks into paying their taxes by pursuing and punishing as necessary those few whom they do audit who do not follow the law and/or pay the appropriate taxes. By making examples of them (yes the IRS specifically issues press releases when they get someone on tax fraud to scare the rest of us) the hope is that they get better compliance.

 A hot issue for the IRS is the issue of whether someone whom a business pays for services is an employee or an independent contractor. This is all about employment taxes. Independent contractors are just that, independent, and because of that those who pay them for their services aren’t required to withhold taxes from that pay, nor do they bear the burden of employer borne taxes (employer share of FICA, Medicare, unemployment taxes). Employees require the withholding taxes and employer taxes mentioned above and also generate other related costs such as worker’s compensation, safety and training, payroll processing costs, etc. This motivates employers to treat workers as independent contractors.Whether a given person who performs services for you is or isn’t your employee is not a choice you make, but a matter of law based on whether the level of oversight on a given person creates an employment relationship.

There are three areas the IRS looks at when making a determination about the status of a given worker and the business:

1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?

2. Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)

3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

It is important to note that the IRS does not require a preponderance of evidence pointing to one status, if it finds even one aspect of the relationship that implies employment; they may pursue the business for the employment taxes due. This can be costly which is why it is important to seriously consider the risks when paying folks for their services. I could fill pages with examples, IRS regulations and court cases. Rather than do that, I ask that if you have some folks you treat as independent contractors and have any concern they may be employees, call me and let’s talk about that relationship and make sure it is being handled properly. This issue is front and center for the IRS. If you are audited this issue will definitely be addressed. If your tax returns indicate that you may be improperly classifying workers as independent contractors, that issue may create an audit. It is truly best to toe the line on this one.