The IRS recently issued News Release FS-2015-21 to remind employers to properly classify their workers as employees or independent contractors.  This issuance is a response to its audit of approximately 6,800 employment tax returns of both taxable and tax-exempt entities during 2008 to 2010.  These audits revealed major reporting problems in multiple areas that led to inaccurate and incomplete returns.

Why it matters if a worker is an Employee versus an Independent Contractor:

Employers must withhold the following for Employees:

• Income Taxes
• Social Security Tax
• Medicare Tax
• Unemployment Taxes (except for Section 501(c)(3) organizations)

An employer is not required to make these payments to Independent Contractors.

If an organization classifies an employee as an independent contractor without a reasonable basis for the classification, the organization, or the responsible person within the organization, may be held liable for the employment taxes of that worker.

Furthermore, a misclassified worker as an independent contractor when they should be an employee leaves the organization liable to retirement plan benefits.  The same is also true for health insurance to both an employee and her dependents.

While there is no bright line rule in segregating employees and independent contractors, the IRS generally looks at the degree of an organization’s control over the worker.  This control is divided into three categories:

1. Behavioral Control: The organization legally has the right to control an employee (whether they exercise it or not) in both
   1. What must be done
   2. How it must be done

An employer may only control what must be done for contractors.  The organization may not control how, when or where the work is performed.  Commonly classified contractors are accountants, lawyers and doctors.

2. Financial Control: How the worker is paid affects her classification.  If expenses are reimbursed and tools are provided by the employer, than the worker is an employee.  Workers who need to furnish their own tools and supplies are indicators of contractors.
3. Type of Relationship: If there are written contracts between the parties, then it will dictate employee or contractor.  If there are employee-type benefits, such as retirement plans, insurance or vacation pay, then the worker is likely an employee. 

What to do if you have misclassifications:

The IRS has two options to come clean on worker misclassifications:

1. Classification Settlement Program:

If an employer is under audit by the IRS, this program allows employers have the option to pay only a portion of the employment tax due for the year under audit that the workers were misclassified.

2. Voluntary Classification Settlement Program (VCSP):

This program is optional, and lets employers voluntarily classify their misclassified workers as employees in future years.  The employer can do so by filing form 8952.  The IRS will usually significantly reduce the federal employment tax liability for past nonemployee treatment.  The requirements for this program are:

1. The employer must have consistently treated workers as contractors
2. The employer must have filed 1099 forms for those workers for the prior three tax years

How do I determine if my workers are employees or contractors?

Organizations can file Form SS-8 with the IRS.  The IRS will examine the facts and circumstances presented, and give an official determination on the status of the worker.  This form may be filed with the IRS free of charge.

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