It’s not unusual for today’s fast-moving, multi-tasking businesses to turn to independent contractors for specialized services. After all, it’s often cheaper and more flexible to hire a freelancer, consultant or project worker than to invest in a full-time employee.
Done properly, this is perfectly acceptable.
Yet the IRS estimates that three out of every 10 workers are misclassified. When businesses get it wrong – either accidentally or intentionally -- they don’t pay payroll taxes, Social Security, Medicare and unemployment insurance.
This is a red flag for the IRS and Department of Labor, and can lead to huge penalties for the employer.
Admittedly, the rules surrounding classification are complex. Here’s some general guidance on the differences between the two types of workers, so your clients can make smarter decisions.
Testing, Testing
There are several different tests used by federal and state agencies, many of which overlap. It’s important to recognize that no single factor with any test is definitive.
Rather, it’s a combination of factors that add up to a decision.
For example, the IRS uses the “Right to Control” test, also known as the “Common Law” test. It looks at factors across three categories:
- How you behave toward the worker
- The financial arrangement with the worker
- The nature of the relationship with the worker
No. 1 – In the behavior category, you’re considering whether you act like a “boss,” specifically:
- Do you dictate how, when and where to do the work? This includes setting the work hours, assigning a workspace or requiring the person to work at your location, and providing tools and equipment, such as a computer.
- Do you provide training to do the work? You may need to provide an orientation on your business, your products or your customers, but you shouldn’t be teaching essential skills.
- Do you monitor performance? You can ask for progress reports with projects, but you shouldn’t be conducting performance reviews or taking disciplinary action.
- The more "no's" you answer here, the more likely you’re working with a contractor.
No. 2 – In the Financial category, these are the key questions:
- Does the worker pay for his/her own business expenses? Although the worker may bill you for some of those expenses, he/she pays them up front. There may be ongoing fixed expenses, too, like a business license or advertising.
- Does the worker own or lease equipment or facilities? This may include a computer, a work vehicle with tools on it, and an office or shop.
- Does the worker have other customers or clients?
- Is the worker paid by the project (not “on the clock” or a salary)?
- Does the worker have potential for profit or loss?
- In this list, you’re looking for mostly "yes" responses.
No. 3 – Finally, how is the Relationship set up between the employer and worker?
- Is the worker eligible for paid time off or other benefits?
- Is the relationship permanent or long-term?
- Does the worker provide core business services?
The more no's you answer here, the more likely you’re working with a contractor.
Remember: You’re looking for the majority of factors to indicate independent contractor status, but not necessarily all of them.
Also, you should be aware of a second type of test, the “Economic Reality” test that’s often used by the DOL and OSHA. It’s broken down into six factors: right to control, investment, length of relationship, skill, level of risk and integration.
Basically, this test assumes an independent contractor has advanced skills, makes independent, financial-related decisions and doesn’t do work that is deeply integrated with the services of the business (similar to the “core” factor with the IRS test).
Uncle Sam is Always Watching
Since the rules surrounding worker classification are complicated, your clients may come to you for expert guidance. Providing specific direction on the IRS and DOL tests can increase your value with small business clients – and help protect them from devastating misclassification penalties (and even lawsuits).
Richard Roddis 2
Rick Roddis is president of ComplyRight Distribution Services, a division of ComplyRight Inc., which provides cutting edge compliance products and programs for businesses. Rick began his career as an insurance underwriter, but quickly moved into sales, operations and management roles at different companies that partnered with Intuit, Staples, Office Depot, and others. In 2008, he became president of TFP Data Systems, the leading manufacturer of 1099, W-2 and ACA tax forms, envelopes and software. Over the past four years, he has been focused on transforming ComplyRight Distribution from a traditional 1099/W-2 forms manufacturer to a digital provider of Tax Solutions for businesses thru services like EFile4Biz and several other digital assets.