Section Library
Employee VS. Independent Contractor
If your section wanted to hire a worker, would that person be classified as an employee or an independent contractor? To you this may seem to be an inconsequential question, however, audits in this area have proven to be lucrative to the Internal Revenue Service (IRS). Meaning, the IRS will continue to audit.
The IRS estimates that it loses $1.5 billion annually in income, Social Security, and unemployment tax revenue from misclassifying workers as independent contractors. IRS has developed new techniques to identify misclassified workers.
Workers are often misclassified as an independent contractor because of economics and ease. An organization classifies a worker as an independent contractor because of:
- lower taxes,
- fewer payroll-accounting concerns,
- not providing benefits,
- avoiding laws governing minimum wage, and
- not paying worker's compensation insurance.
However, the IRS has specific guidelines on determining the status of a worker. Basically, if the control is primarily in the hands of the employer, then the worker is an employee; if the control is primarily in the hands of the worker, then the worker is probably an independent contractor.
No single factor determines whether a worker is an employee or an independent contractor. Use the following information to determine whether or not the section's worker is an independent contractor or an employee.
|
Factor |
Suggests Employment |
Suggests Independent Contractor |
|
1. Instructions |
Firm instructs on location, hours, methods, etc. of service, or firm has right to do so. |
Absence of firm's right to instruct on location, hours, methods, etc. |
|
2. Training |
Firm provides training. |
No training by firm. |
|
3. Integration |
Worker's services are integral part of firm's operation and critical to firm's success. |
Worker's services are incidental to firm's operations. |
|
4. Services rendered personally |
Worker must render services personally. |
Worker can delegate or subcontract. |
|
5. Hiring, supervising, paying assistants |
Worker may hire, supervise, pay assistants only with firm's approval. |
Worker has discretion to hire, supervise, and pay assistants. |
|
6. Duration of relationship |
Lengthy, indefinite, or otherwise open-ended. |
Limited in time or as to specific result. |
|
7. Hours of work |
Set by firm or inflexible. |
Set by worker. |
|
8. Amount of time required |
Substantially full-time. |
Less than full-time. |
|
9. Work place |
Firm's premises. |
Off premises of firm. |
|
10. Order or sequence of work |
Set by firm. |
Set by worker. |
|
11. Reports |
Worker provides oral or written progress reports. |
No reports provided by worker. |
|
12. Methods of payment |
Hour, day, week, or other measure of time. |
Not time based; lump sum, piece work, etc. |
|
13. Business/travel expense |
Reimbursed by firm. |
Paid by worker without reimbursement. |
|
14. Tools/materials |
Provided by firm. |
Provided by worker. |
|
15. Significant investment |
Firm provides facilities, equipment, etc. |
Worker provides facilities, equipment, etc. |
|
16. Realization of profit or loss |
Worker cannot realize profit or loss (risk of nonpayment not viewed as loss by IRS). |
Worker has risk of loss (investment/expenses, fixed price dependent on outcome, etc.) |
|
17. Work for multiple firms |
Worker has exclusive relationship with firm. |
Worker has multiple clients. |
|
18. Making services available to public |
Worker doesn't hold self out to public. |
Worker advertises or has own office, has business cards, etc. |
|
19. Firm's right to fire |
Firm can fire worker at will |
Worker cannot be fired at will during contract term/ project w/o firm liable for breach. |
|
20. Worker's right to quit |
Worker may quit at will. |
Worker must complete term/ project or be liable for breach of contract. |
These factors are only several of the 20 factors that the IRS uses to determine worker status. The more details and means that a section has over a worker's activities, the more the relationship becomes an employee rather than an independent contractor.
By completing and mailing IRS Form SS-8 (Section 9 of the Appendix), the IRS will make a determination of worker status. There is no set time limit during which the IRS must respond to this request; it may not make a resolution for more than a year.
The 1989 Revenue Reconciliation Act provides for a $250 Return Preparer penalty for negligent disregard of the tax rules and regulations. This penalty also applies to return preparers if:
- Any part of the understatement of the liability is due to a position for with there is not a realistic possibility of being sustained on it merits (i.e., reasonable and well informed analysis by a person knowledgeable in tax law would lead such a person to conclude that the position has approximately a 1 in 3 or greater likelihood of being sustained on its merits).
- The paid return preparer knew or should have known of the questionable position; and
- The position in question was not disclosed on the return in a way provided by the IRS.
- Interest on tax underpayments is currently payable to IRS in the amount of 8%, compounded daily. The interest rate on underpayments fluctuates periodically.
- An employer's downside risk of IRS disallowance of independent contractor status may include the following assessments against the employer:
- 7.65% of the (employer share of FICA tax) of the worker's pay.
- Additional tax in the amount of 20 percent of the worker's share of FICA and Medicare taxes.
- Additional tax in the amount of 1.5 percent of the worker's Federal withholding taxes.
- FUTA tax, typically in the amount of 6.2% of the workers' pay up to $7,000 per worker.
- Additional penalties. The bill for IRS back taxes and related penalties and interest can be a minimum of 10.68% (and is usually more) of the employee's back pay. Furthermore, criminal penalties may be enforced.
- Interest expense. The rate is the Federal short term rate (currently 8-9%) plus 3%.
Additionally, independent contractors may sue and collect for unwithheld taxes.
If the IRS audits an employer regarding the independent contractor issue prior to the time a state taxing authority does, the IRS may later notify the appropriate state governmental taxing authority and a corresponding state unemployment (or other tax) audit may (probably will) follow. The same holds true in reverse: if the state audits an employer prior to any IRS audit, the state may later notify the IRS and a Federal audit may follow.
Because many states have "tattletale" provisions as described above, the following additional taxes and penalties may apply:
- State unemployment taxes;
- State withholding taxes;
- City and County withholding taxes
- Penalties on above (similar to above described Federal penalties);
- Interest
Associations are being targeted for contractor/employee audits because misclassification abuses occur most frequently in the nonprofit sector.
Remember, the key is control, or the right to control, as to the details and means by which a service is accomplished. The more control, the better the likelihood that this worker is an employee. If a worker is subject to control only as to the result of the work, the worker will probably be considered an independent contractor.