Should I Treat my Workers like Employees or Contractors?

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When workers are treated like employees, the employer is required to withhold federal, state and local income tax from the employee’s paycheck and pay such income tax withholdings to the appropriate government agency.  Furthermore, when workers are treated as employees, the employer is required to withhold and pay-over the employee-portion of the social security tax (6.2% on wages up to the wage base limit) and the medicare tax (1.45% on wages without limit), and to pay the employer-portion of the social security tax (also 6.2%) and the medicare tax (also 1.45%). 

     When workers are treated as independent contractors, the employer is not required to withhold income tax or payroll tax from the workers paycheck, and is not required to pay the employer-portion of social security or medicare tax.  Rather, the worker is treated as self-employed, and is personally liable to make quarterly estimated payments of income tax and self-employment tax.  Self-employment tax is the functional equivalent of the employer and employee payroll taxes.  Self-employment tax is assessed at the rate of 15.3% on wages up to the wage base limit, then 2.9% on all wages over the wage base limit. 

     When workers are treated like employees, the employer bears half of the payroll tax burden, and has the responsibility to withhold and pay income and payroll taxes to the government.  When workers are treated as independent contractors, the worker bears all of the payroll tax burden, and the employer is not required to withhold or pay-over any tax withholdings.  When workers are treated as contractors, the workers generally do not qualify to participate in group health insurance, retirement plans and other fringe benefit programs established for employees.  For these reasons, employers may see a financial advantage in characterizing workers as contractors rather than employees.

     The IRS looks at worker classification issues closely on audit.  The IRS applies a 20-factor test to determine whether workers should properly be classified as employees or contractors.  Although the IRS test refers to 20 factors, the IRS test really boils down to 2 main issues.  First, does the employer control the manner and methods by which the worker does his or her job?  That is, does the employer control the worker to the extent that the employer tells the worker how, where and when to do the job?  

     Second, does the worker have a risk of loss on the job?  A contractor has to run a business and pay bills.  The cost of labor and supplies on a job may exceed the amount the contractor collects on the job.  On the other hand, employees are paid a set wage by the hour, day, week or other period, and employee expenditures are often reimbursed.  So employees do not generally have a real risk of loss.

     If the IRS determines that an employee has been misclassified as a contractor, the IRS will generally look to the employer to make-up both the employer and the employee portion of income and payroll taxes.  If the employer is insolvent and cannot pay such taxes, the IRS will go after any responsible party.  For this purpose, a responsible party is any person who had the apparent power and authority (ie, a corporate officer) to make decisions concerning which creditors were paid. 

     Misclassification of workers can be a very expensive mistake.  The employer may need to pay income and payroll tax, penalties and interest, and may need to make additional contributions to employee retirement, health insurance and other fringe benefit arrangements.   There are some defenses and safe-havens available when the IRS questions worker classification.  But it is better to assess your situation now, and either correct your classification or prepare your defense strategy, before the IRS raises the issue.  If you want to discuss worker classification issues, please give me a call.   Jsenney@pselaw.com or 937-223-1130.

     AND ONE MORE THING.  How long has it been since you had a Legal Audit?  The Business attorneys at PS&E would like to meet with you and do a free legal audit of your company.  As part of the legal audit, we will work through a checklist with you and identify areas where you may be at risk.  If you would like to schedule a free Legal Audit with one of the PS&E attorneys, please send me an email or give me a call.  Jsenney@pselaw.com or 937-223-1130.