If not, your company may be at risk for business, tax and legal liabilities
Consider this conversation between a company’s CEO and general manager:
CEO: “We need to hire 30 people to design and roll out our new product. But our board will be upset if we increase our staff, particularly because we received bad press after our layoffs last quarter.”
General manager: “We were faced with a similar challenge at my last company. Rather than putting workers on the payroll, we hired them as independent contractors and had each person sign a contract stating that they weren’t our employees.
“We paid them through accounts payable, which saved us a significant sum because we didn’t have to pay unemployment, Social Security or Medicare taxes or withhold income taxes. We were also protected from discrimination claims because they were classified as independent contractors and not as our employees. And, we didn’t have to list them as new hires on our reports to the board.”
CEO: “That could work for us. Let’s try it out.”
Although this plan sounds like it will save you money and avoid potential negative PR, the organization will assume significant business, tax and legal risks if it misclassifies workers as independent contractors. In addition, the IRS is increasing pressure on employers to collect more employment taxes. And misclassified workers now must file Form 8919, which will report the misclassified employee’s share of uncollected Social Security and Medicare taxes.
Before you make a mistake, understand how the IRS classifies workers and review ways to minimize your liabilities.
Realize the benefits
Independent contractors are self-employed workers hired to perform a specific task for an employer. The trend of using these workers has increased significantly in recent years.
Why the increase in the number of independent contractors? Businesses are realizing the benefits of hiring them. For one, your future unemployment tax rate will not be affected if you fire them. Next, independent contractors may already have their own equipment and health insurance, which would be a cost savings to you. Finally, it can be psychologically easier to terminate a contractor than an employee — a contractor will probably have less of a relationship with you or co-workers.
Determine the correct classification
You may generally classify workers as independent contractors if you have the right to control or direct the result of the work, but not the means and methods of accomplishing the result, according to the IRS. If you (the employer) can control how the work will be accomplished, you must classify the worker as an employee.
For example, Max is a graphic artist who designed and maintains the Web site for Widget Corp. Although Max performs the majority of his work in his home office, the company assigns him particular days and times he must be “on the job” and controls the work because the marketing director must approve all his output before it’s posted.
Because Widget closely monitors Max’s work, including assigning it and approving it, the company must classify him as an employee. If the business allowed Max to do the work on his own schedule and didn’t control how it was done, Widget could classify him as an independent contractor.
The rules are ambiguous in this area and subject to the individual facts and circumstances of each employer.
Examine the employer/worker relationship
Under common law, determining whether a worker is an independent contractor or an employee requires you to look at the relationship between the worker and your organization. Here are three factors to consider:
- Behavioral control. If your business has the right to direct and control how the work is done (such as through instructions, training or other means), you must classify the worker as an employee.
- Financial control. If your business has a right to control the financial and business aspects of the worker’s job, you must classify the worker as an employee. (An independent contractor can make a profit or a loss.)
- Type of relationship. If your business provides the worker with benefits such as insurance and paid time off, you must classify the worker as an employee.
Understand the consequences of misclassification
The consequences of misclassifying employees as independent contractors can be damaging. Not only may you be liable to the IRS for back taxes, interest and penalties, but you could owe back and front pay, attorneys’ fees and compensatory and punitive damages.
It appears that worker classification is going to be a top item on the Texas Workforce Commission’s (TWC’s) audit agenda this year. The federally funded agency’s audit quota has been increased, and in its audits the TWC is required to look for misclassified workers. The agency also has the legal authority to reclassify workers as employees.
In other worker classification developments, beginning with the 2007 tax year, employees who’ve been misclassified as independent contractors by their employers must file Form 8919 “Uncollected Social Security and Medicare Tax on Wages” with the IRS. This form will determine and report the employee’s share of uncollected Social Security and Medicare taxes due on his or her compensation. (Previously, misclassified workers typically used Form 4137.)
By filing Form 8919, the misclassified employee’s Social Security and Medicare taxes will be credited to their Social Security record. To streamline this process, the IRS will electronically share Form 8919 data with the Social Security Administration.
Save time and money
Like many businesses, yours could benefit from additional labor from time to time. Be sure to take care when classifying workers as independent contractors or temporary employees. Otherwise, the time and money you saved by hiring these workers will be for naught.
For more information contact:
Marie Brehm, CPA, Partner
Director of Business Services Group
Weaver and Tidwell, L.L.P.
mkbrehm@weaverandtidwell.com
972.448.9250 Phone
972.702.8321 Fax
www.weaverandtidwell.com