Using Independent Contractors? Beware!

If you use independent contractors in your business, be sure that you’ve classified them properly and not simply chosen to treat workers as independent contractors (IC) when they are actually employees.

Many business owners prefer IC classification because it saves the company considerable money. The company doesn’t have to pay employment taxes, workers’ compensation, or employee benefits, such as health insurance or retirement plan contributions, saving the company 20% or more in contrast to having an employee.

But the company’s preference is not the determining factor in worker classification, and the government is looking closely at businesses to make sure that workers aren’t being misclassified. The reason: Revenue. The government believes that ICs fail to report 30% of their income. And additional revenue loss results as follows:

  • The federal government loses out not only on income taxes not paid by the ICs, but also employment taxes (Social Security and Medicare taxes as well as federal unemployment insurance) not paid by the company.
  • States lose out on unemployment insurance not paid by the company, as well as income taxes (where applicable) not paid by the ICs.
Government Interest in Worker Classification

The federal government estimates that 3.4 million workers are misclassified as ICs. Many states have their own estimates about misclassified workers. The Obama administration’s budget proposal ( for fiscal year 2011 includes measures to raise about $7 billion in the next 10 years by providing $25 million additional funds for the Department of Labor (DOL) to hire 100 additional enforcement personnel to work on ensuring proper classification. Also, the DOL and Treasury Department would work together to eliminate incentives for employers to misclassify employees as independent contractors.

Current Safe Harbor

The determination of whether a worker is an employee rests with “control.” Generally, if a company has the right to say when, where, and how a job is performed, the worker is an employee. Having an independent contractor agreement labeling the worker as an IC doesn’t count for tax purposes (although having one doesn’t hurt).

At present, a company can use a “safe harbor” and continue to treat a worker that has been classified as an IC as such for employment tax purposes if one of the following four conditions is met:

  • A past IRS audit with the company did not change worker classification.
  • There is a case or ruling that supports this worker classification.
  • There is long-standing recognized practice in the industry in which the company is a member that treats workers as ICs.
  • Any “reasonable basis” for treating a worker as an IC.

The Administration supports a change in the safe harbor rules, which would make it harder for companies to escape employment taxes.

What to Do Now

As yet, there have been no changes (only proposed changes) in worker classification rules. The IRS continues:

But if the IRS audits a company and reclassifies workers, the cost can be financially devastating—back employment taxes for the government and back benefits for workers. Companies need to work closely with their tax advisors to review their worker classification and follow these guidelines:

  • Be consistent. If you’re already treating workers doing certain tasks as employees, don’t start to treat them as ICs. And be sure to treat all workers doing the same task in the same way, either as employees or ICs, depending on the circumstances.
  • Find a basis for the classification you’re using (e.g., some precedent established), so at least you’ll have a safe harbor to rely on.
  • Issue a Form 1099-MISC each year to any IC who earns $600 or more from you.
  • Stay vigilant about possible law changes that could impact your worker classification. Even without law changes, expect the IRS and states to look very closely at all businesses, especially those in construction and trucking (where IC classification is common and labor unions are pushing for reclassification).
  • Learn more about worker classification from the IRS.

Barbara Weltman is a top selling author, attorney, tax and small business expert. Barbara’s books include “J.K. Lasser’s Small Business Taxes” and “The Complete Idiot’s Guide to Starting a Home-Based Business.”

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