Employee vs. contractor: What employers need to know

The composition of the workforce has been changing rapidly during the past decade, and it’s likely that the people who handle the work at your company today are some mixture of traditional employees and independent contractors.

Independent contractors enjoy the benefits of greater flexibility in work schedule and location and are able to pursue multiple entrepreneurial opportunities for themselves. Companies gain an on-demand workforce that can scale with the ebb and flow of business without the long-term costs and commitments of hiring full-time employees.

An estimated 10.3 million U.S. workers are independent contractors, according to 2010 U.S. Census Bureau data, and some have dubbed the new world of work the “1099 Economy” in recognition of the tax form filed by independent contractors.

But as innumerable employers continue to discover, it’s not always easy to tell whether an independent contractor is actually an employee. And as many companies have learned the hard way from the Internal Revenue Service, failure to categorize workers properly can be expensive.

Employers have a powerful motivation to classify workers as independent contractors. As a general rule, they aren’t required to withhold income taxes, withhold and pay Social Security and Medicare taxes or pay unemployment tax on wages paid to contractors.

But the economic forces that spur the use of independent contractors also mean that the IRS pays close attention to ensure your company pays the taxes — all the taxes — that it owes.

If you’re one of the many companies that use independent contractors, how do you make sure you won’t face the penalties, back taxes and interest that can come from mis-classifying a worker as an independent contractor?

Start with careful, ongoing analysis of the classification of your workers. Do it right the first time, then keep an eye on things to make certain the relationship hasn’t changed.

The IRS pays attention to control and independence as it weighs whether workers are classified properly. And while there are no hard-and-fast rules, the federal agency weighs 20 separate aspects of the relationship between your company and the worker.

For instance, IRS says workers who are provided detailed instructions about their duties — when they’re expected to do the work, the tools they’ll use — generally are considered employees. Workers who receive training from the company are likely to be considered employees.

Workers who maintain a separate location, advertise services to other possible clients and stand to make a profit or loss on the work are more likely to be considered as independent contractors.

If your company provides benefits to a worker, the IRS is likely to consider the worker to be an employee. (But a cautionary note: Just because your company doesn’t provide benefits to workers doesn’t mean that they all are independent contractors.)

It’s definitely worth your time to take a look at all of the elements that the IRS uses to classify employees and independent contractors. See “Independent Contractor (Self-Employed) or Employee?” on IRS.gov for a full discussion.

So what happens if you find you erroneously classified some employees as independent contractors in recent years? You may face less trouble than you fear.

The IRS continues to offer what it calls the “Voluntary Worker Classification Settlement Program” that provides leniency for companies that decide to address the program on their own.

Nearly 1,000 companies nationwide have applied for the program since it was launched a couple of years ago. Most of them want to avoid the stiff penalties that likely await them if the IRS decides on its own to reclassify independent contractors as employees.

The IRS explains that the program provides “partial relief from federal payroll taxes for eligible employers who are treating their workers or a class or group of workers as independent contractors or other non-employees and now want to treat them as employees.”

The program provides leniency to tax-exempt organizations and government entities as well as businesses.

What employers are eligible? The IRS says they must be currently classifying the workers as independent contractors, and they must have consistently treated the workers in the past as independent contractors. (For instance, the employer should have routinely provided Form 1099 notices to the workers.) Employers who are currently being audited by the IRS for payroll tax issues don’t qualify.

The employers that are accepted into the program generally pay an amount that’s equal to slightly more than 1 percent of the wages paid to the reclassified worker in the past year. The program eliminates interest and penalties. The IRS pledges that employers accepted into the voluntary program will not be audited on payroll taxes related to the reclassified workers’ prior work.

Given the complexities of the classification of employees and independent contractors, and given the costs of getting it wrong, it obviously makes sense to get qualified professional advice whenever questions arise. And you almost certainly want a skillful advisor standing next to you as you consider entering the voluntary IRS settlement process.

John Solari is the owner of J.A. Solari & Partners, a Reno firm specializing in accounting, tax preparation, business consulting and strategic planning.