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Know the Tax Differences for Independent Contractors

In these days of alternative work arrangements, it's harder than ever to tell the difference between employees and independent contractors. Nevertheless, it's important for employers to make the correct classification.

Reason: If the IRS determines your company has improperly treated a worker as an independent contractor, it can assess payroll taxes on the worker's wages, plus penalties and interest. In addition, the business can be hit with a penalty for failure to withhold income taxes on the worker's wages equal to 1.5% of the wages paid and a penalty equal to 20% of the employee's share of payroll taxes.

In the past, the IRS has utilized a list of 20 main factors to determine whether a worker was an employee or an independent contractor. However, a recent training manual for IRS agents emphasizes that certain factors that have traditionally affected employee status may have little relevance today. For example, whether or not work is performed on the business's premises often has no bearing on a worker's status. Modern technology, such as modems and computer networks, has expanded the scope of the workplace so that many employees now work off-site. Similarly, part-time work and flexible hours, which were once hallmarks of independent contractor status, may now be consistent with either employee or independent contractor status.

Instead of a lengthy factor-by-factor analysis, the IRS now says worker classification involves an analysis of three key factors.

1. Behavioral control: Evidence showing that the business has the right to direct and control the means by which the worker performs the required services tends to indicate that the worker is an employee. On the other hand, directions concerning what should be done, but not how it should be done, are often consistent with independent contractor status.
   
2.  Financial control: The financial arrangements between the parties could indicate which party has the right to control the business aspect of the job. The ability to realize a profit or incur a loss is the strongest indicator that the worker is the one in control and may be an independent contractor.
   
3.  Relationship between the parties: The legal and contractual relationship between the parties may also be important in determining a worker's status. For example, providing employee-type benefits to the worker, such as paid vacation days, insurance or retirement benefits, is a trait of employee status. Similarly, the right to discharge the worker without penalty may be indicative of employee status.

Of course, your company may be entitled to special protection from reclassification if there is a "reasonable basis" for treating a worker as an independent contractor. To qualify, you must have consistently treated the worker (and similarly situated workers) as independent contractors and filed federal tax returns consistent with that treatment.

There are also a number of "safe harbors" for establishing a reasonable basis-such as a court decision or official IRS ruling that classified similar workers as independent contractors, a private letter ruling from the IRS classifying the particular worker as an independent contractor, a prior IRS audit that did not find similar workers to be employees or a long-standing practice in the employer's industry.

Due to the amount of money that could be at stake, make sure that your company is on firm ground. Expert assistance is just a phone call away.

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