The cost of misclassifying employees as independent contractors

When the economy went south in 2008, Maggie, the owner of a carpet cleaning business, was forced to lay off staff. Now that business is improving, she needs more help but doesn't want the overhead — or commitment — associated with hiring employees. So Maggie decided to use independent contractors. They work similar hours and perform many of the same tasks as Maggie's employees. But the contractors have signed agreements stating they'll work for a certain fee and pay their own FICA, unemployment and workers' compensation taxes. What works for Maggie and her new workers should work for the IRS, right? Wrong.

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Severe consequences

In general, the IRS prefers employees. It's easier and cheaper to collect taxes from a single employer than multiple independent contractors, so the agency actively looks for employees misclassified as contractors by their employers.

The consequences of misclassifying workers can be severe. You may owe back payroll taxes that you should have paid and the employee's payroll and income taxes that you should have withheld, as well as penalties and interest. And the IRS could hold you and other "responsible persons," such as managers, personally liable for uncollected taxes. Finally, your state may impose its own penalties.

Determining factors

Unfortunately, there's no simple formula for determining whether a worker qualifies as an independent contractor. The IRS considers a number of factors. However, you may be working with a contractor if you have the right to control the result of the work, but not the means and methods of accomplishing it. If you can control how the work is accomplished, you'll probably need to classify the worker as an employee.

Workers may also be considered employees if they:

  • Work on-site in an assigned space or office,
  • Work a set number of hours per day or week,
  • Are directly supervised by company managers, or
  • Use company-owned transportation, equipment and supplies.

For example, Maggie schedules appointments for her contractors and expects them to perform their jobs according to her instructions, using her vehicles and supplies. The IRS likely would consider these workers employees, not contractors.

Independence is key

As the economy improves and your business picks up, you may decide to hire new workers. If you aren't sure how to classify them, talk to a tax expert. •


Other articles in the June 2012 Edition of Business Matters: