Classifying an Independent Contractor

Independent contractors can provide valuable assistance to businesses.  However, there can be IRS penalties if a business is wrong when classifying someone as an independent contractor rather than as an employee.  It is helpful to seek the advice of an attorney regarding the facts of your specific situation, but here are some factors and rules of thumb to keep in mind.

An independent contractor will not be entitled to benefits that an employee has, and employers are not required to withhold social security and other items from their compensation. For this reason, the IRS can issue penalties to an employer that improperly classifies someone as an independent contractor. 

1. Potential Penalties

If the IRS determines that contractors should have been classified as employees, the IRS may require the employer to pay back taxes (including the employees’ share of unpaid payroll and income taxes), plus penalties and interest. And if the employer lacks the resources to pay these liabilities, the IRS can collect from “responsible persons,” including certain executives, partners or managers. Federal and state tax authorities can also impose penalties on employers who misclassify workers even if all their contractors satisfy their tax obligations. See Internal Revenue Code section 3509 for more information.

2. Common Law Rules

The IRS will consider the degree of control the company exercises, and independence of the alleged employee:

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 work controlled by the alleged employer?  The IRS will consider how worker is paid, whether expenses are reimbursed, and who provides tools and supplies necessary to complete the work.
3. Type of Relationship: Is there a written contract or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed the “bread and butter” of the alleged employer?

Businesses must weigh all these factors when determining whether an individual is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that indicates worker is an employee or an independent contractor.  No one factor determines the issue.

It is important to look at the entire relationship, considering the degree or extent of the right to direct and control.  A business should also document each of the factors used in coming up with the determination.

A full list of the 20 factors the IRS considers are available here. 

3. Resolve Questions by Filing Form SS-8 with the IRS

If, after reviewing the factors, it is still unclear whether a worker is an employee or an independent contractor, you can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding with the IRS. The form may be filed by either the business or the worker. The IRS will review the facts and circumstances and officially determine the worker’s status.

Be aware that it can take at least six months to get a determination, but a business that continually hires the same types of workers to perform particular services may want to consider filing the Form SS-8.  A business should be very cautious before contacting the IRS.  A business should consult an attorney and potentially a tax expert before contact the IRS in case the request causes an audit of the business’ operations.

Many small businesses would appreciate the opportunity to quickly scale up and down, as their business necessitates.  However, it is important to go through a thorough analysis of whether an independent contractor is properly classified.  There can be IRS penalties if an employer is wrong on this. To discuss independent contractor classification, call our Sioux Falls, Sioux City, or Omaha office today.

The Author, Angela Madathil, is an Employment Attorney licensed to practice in Kansas and Nebraska.  The Goosmann Law Firm has team members licensed in Iowa, Kansas, Minnesota, Missouri, Nebraska, South Dakota, and other states. Angela Madathil assists clients throughout Nebraska including those in Omaha, Papillion, and Bellevue, Nebraska.