Payments to Contractors is one of the top 21 small business tax deductions reported by business owners in their Profit & Loss Statements. This expense is also heavily scrutinized by both the IRS and State Taxing Authorities during an audit, the scrutiny is usually not related to the amount paid to a contractor but whether that individual is truly a contractor or should instead be classified as an employee. In this article, we discuss the pitfalls of misclassifying workers as contractors vs. employees, some recent development that all business owners should pay attention to, and best practices to avoid onerous fines due to misclassification.

What are the benefits of classifying someone as a contractor vs. an employee?

While both Contractor Payments and Employee Wages are a deductible expense to a business, there are some major advantages of classifying someone as a contractor. Businesses do not pay employer payroll taxes when paying contractors, this could result in a potential cost-saving between Federal and State of more than 9% of the amount paid. Contractors do not have access to the same level of benefits extended to employees like access to company retirement plans and employer pension and profit-sharing matches, contractors don’t often qualify for expense reimbursement costs like mileage or supplies used while working. Therefore, classifying an individual as a contractor vs. an employee can be extremely cost-effective for a business. This is the primary reason Uber and Lyft classify their drivers as contractors rather than as employees.

What are the drawbacks of misclassifying someone as a contractor rather than as an employee?

You could be facing major fines and penalties if the IRS and/or State auditor finds that you intentionally and willfully misclassified an individual as a contractor when this person should be considered an employee. In these cases, a business owner can see payments to contractors reclassified as wages and salaries, when this happens the business could see massive penalties also known as Trust Fund Recovery Penalties. Failure file W-2s can also be a huge fine that can be imposed on your business for misclassifying a contractor.

How the IRS Determines Independent Contractor Status?

The IRS has several tests it implements in order to determine if someone is truly an independent contractor however, these test usually boil down to three major questions:

  • Do you have behavioral control?
    • When and where to do the work.
    • Who owns the tools or equipment used.
    • What workers to hire or to assist with the work.
    • Where to purchase supplies and services.
    • What work must be performed by a specified individual?
    • What order or sequence to follow when performing the work.
  • Do you have Financial Control?
    • A contractor using his own equipment.
    • Expenses are not reimbursed.
    • Contractor free to seek other contractor opportunities with other companies.
    • A contractor is not guaranteed a regular payment amount.
  • What is the business relationship to the Contractor?
    • Written contracts
    • Implied benefits
    • Services provided are a key activity of the business

These are just some of the major tests implemented by the IRS, but what about at the State level? Things can become extremely complicated at this point since every State can adopt their own interpretation of how an individual should be classified as a contractor rather than an employee. Therefore, it is very important that you understand how your individual State classifies contractors vs. employees.

How can the California new Assembly Bill 5 impact businesses across the country?

In Mid-September 2019 California Gov. Gavin Newsom signed into law Assembly Bill 5, also known as AB5, which classify some independent contractors as employees. This bill directly impacts independent contractors currently working with Uber and Lyft. Both companies have expressed major concerns with this bill and have vowed to fight it vigorously. One of the major unknowns related to this bill is whether the law will allow individuals previously classified as contractors to sue their employers and request that they are classified as employees retroactively. This is a question that most likely will end up being argued before the California Supreme Court. Why should a business in another state care about the new California Assembly 5 Bill? Because this bill is set to potentially pave the way for other States to do the same, New York and New Jersey have expressed interest in adopting a similar version of this bill in their state. Therefore, it is crucial that you remain updated on these developments. Unfortunately, most business owners do not have the time and technical knowledge to evaluate how these changes will impact their businesses. This is one of the reasons you really need to work with an Accountant if you do not have one.

What are my options if I might have misclassified an individual as a contractor?

The pressing questions for most business owners are: What happens if you have been misclassifying employees as contractors? is there anything that can be done to mitigate those major penalties and fines we identified earlier in the article? Yes, there are options that should be carefully considered.

First, contact an accountant to represent your best interest during this process. Federal and State tax laws are complex, and you do not want to make any statements to an IRS or State auditor that could worsen your situation.

If your business qualifies, the IRS offers an exception under Section 530 that would allow you to avoid paying employment taxes on wages for those works that have been misclassified as contractors. Section 530 of the Internal Revenue Code allows protection from liability or payment if the person or business can show a good faith effort to comply with the law. Usually, this means compliance with specific requirements therefore, documentation, in this case, is essential.

The IRS also allows you to Apply for Worker Status Determination using Form SS-8. In this case, the IRS reviews your overall situation and issues a determination if they consider your worker an employee or a contractor. The determination is made on a case-by-case basis, and this form cannot be used to ask the IRS on proposed situations. This is a very detailed form that must be filled out and the determination is specific to your individual circumstances.

Final thoughts:

Correcting a misclassification of workers can be very challenging, federal and state tax law coupled with unique circumstances makes these cases very difficult to correct therefore, we cannot stress enough the importance of working with an accountant that can assist in this process.