In this gig economy, a business owner needs to be knowledgeable about the proper classification of employee vs contractor.
Many businesses would rather pay a service provider as a contractor due to the costs associated with hiring employees, i.e. payroll taxes, unemployment taxes, employee benefits, filing requirements. Geez, employees can be very expensive! Although getting audited for misclassifying employees as independent contractors can be even more expensive! So it’s critical as a business owner to understand the proper classification between the two.
What is the difference between an employee and contractor? Although businesses many times believe that this is a gray area or that the classification is left at their discretion. The IRS, under common law rules, states that if you pay an individual for services, they are your employee.
If you are paying an individual for services classified as an employee by the IRS, you are required to withhold payroll taxes and remit them along with all relevant payroll tax forms.
Not all individuals you pay for services are employees, however, the burden of proof is left with the business owner. The business owner must prove that the person they are paying is not an employee by how much control they have over the individual service provider.
So, how do you prove that the person you are paying is not an employee and instead an independent contractor? The IRS has clear guidance as to how to determine if the person you are paying is indeed an employee and not a contractor by elements of control.
Many times, companies assume that they can simply classify an individual as an independent contractor because it’s convenient for them and the person they are paying tells them that they’d rather be a contractor, WRONG! The question then becomes whether you have the right to control the detail of services being performed by the individual.
It is critical that the business owner knows the difference between these two classifications, as it is highly penalized if improperly classified since payroll taxes are considered trust funds. Payroll taxes are trust funds, meaning property of the federal government. By not withholding payroll taxes for an employee, you are essentially taking government money in trust. Trust fund penalties amount to 100% of unpaid taxes plus interest and penalties. In layman’s terms, you are stealing from the government!
Now that I got your attention since you don’t want to get caught off guard misclassifying an employee as an independent contractor during an audit for withholding trust funds from the federal government. In the event of an audit, you must understand how the IRS determines the elements of control for an employee vs contractor.
Before you are quick to classify an employee as an independent contractor, know the type of relationship you have with the service provider, and it has nothing to do with the title you give them.
Following are evidence of the level of control the business owner must consider prior to classifying the service provider:
- Do you control the work and how the work is to be performed?
- Do you provide the tools & equipment to perform the job?
- How do you pay for these services, i.e., do you reimburse them for expenses, provide any benefits?
- Do you have a written independent contractor agreement and completed Form W9?
- Is this service an integral part of your business?
If you are still not sure as to how to classify an individual for services they provide your business, I recommend you seek the help of a tax specialist to avoid creating exposure for your business. Also, know that an audit for misclassification of employees can be initiated at both the federal and state level. This means that you could be subject to penalties for payroll taxes at the federal level and unemployment taxes by the state. Also, know that a defense of an “I didn’t know” won’t fly during an audit by either the federal or state government.
Obedience to the law is demanded and not asked for as a favor.
In the event of an audit, seek professional help, as you would not show up to court without an attorney. I don’t recommend you show up to an audit without proper representation by an experienced tax professional.
We at NES Tax & Accounting have many years of experience representing clients in audits before the IRS and states across the country, so if you find yourself in this situation, reach out to us or seek professional help by an experienced Enrolled Agent, CPA, or attorney.