As a tax attorney I often get asked about the difference between employees and independent contractors, why it matters, and how to choose the proper classification. Properly classifying employees and independent contractors impacts expenses now and, in the future, and has substantial ramifications for those classified as employees and those classified as independent contractors.
Independent contractors are responsible for paying their own self-employment taxes and alleviates the company from paying its share of employment taxes, social security, and Medicare. Additionally, the company does not typically have to pay benefits for independent contractors nor cover the independent contractors under worker’s compensation. From the independent contractor’s point of view, they are not entitled to typical workplace benefits, such as health insurance, retirement plans, vacation days and they are not entitled to claim unemployment.
Employees on the other hand, have half of their payroll taxes paid by the companies they work for, may receive health insurance, the opportunity to contribute to retirement plans, worker’s compensation coverage and other fringe benefits often offered to employees, at the expense of the company.
Given this list of benefits and costs to companies, it is easy to see why employers want to classify their workers as independent contractors whenever possible. While classifying workers as independent contractors may be cost saving for the company, if the workers are improperly classified as independent contractors, the costs will quickly outweigh any short-term cost saving the company enjoyed.
Both federal and state governments take an interest in the classification of workers. In fact, there are at least five different government agencies that have a vested interest in the proper classification of workers, each for a different reason. The Internal Revenue Service (“IRS”) and Utah State Tax Commission are interested for withholding and payroll tax purposes; the U.S. Department of Labor (“DOL”) is concerned with minimum wage and overtime pay; the Utah Department of Workforce Services (“DWS”) is interested for unemployment insurance requirements; and the Utah Labor Commission is interested for worker’s compensation purposes.
To top it all off, each agency uses its own set of criteria for determining when a worker is an employee or an independent contractor. The IRS has three categories it considers, the DOL has seven factors, the Utah State Tax Commission relies on seven factors, DWS has fifteen factors, and the Utah Labor Commission has four statutory factors it relies on. While many of the factors overlap, it is imperative that employers and businesses make sure they are complying with each agency’s set of factors.
A couple of the common factors that are considered are the amount of control the company exercises over the worker, the length and permanency of the company and worker’s relationship, the risk of profit and loss undertaken by the worker, and the importance of the worker’s performed services to the company’s business. It is important to note that all the agencies say each situation is based on the facts and circumstances and no one factor is determinative. While the agencies will look to the contract between worker and company, the employee classification cannot be contracted around, just because the contract states the worker will be an independent contractor, if a majority of the other factors point to the worker being an employee, the independent contractor will likely be reclassified as an employee.
Any of the five agencies listed above, can investigate the classification of a company’s workers, and each agency can reclassify independent contractors as employees. The consequences for improperly classifying employees as independent contractors will vary depending on which agency make the determination to reclassify. However, all the agencies tend to play nice with the other agencies, so if the DOL decides an independent contractor was really an employee, the IRS, DWS, and the Utah Labor Commission are likely to receive that information and may begin their own investigations.
As an example, if the IRS determines that independent contractors should have been treated as employees, the company misclassifying the workers will be subject to pay its back share of payroll and withholding taxes, plus interest and penalties, which can be as high as 100% of the owed taxes and may result in criminal charges as well. A misclassification determination by other agencies can result in paying liquidated damages for not paying minimum wage or overtime, liability for benefits that should have been provided, unemployment taxes and worker’s compensation coverage, plus interest and penalties. The cost savings enjoyed by classifying a worker as an independent contractor do not outweigh the potential cost of having the worker reclassified, especially given that an investigation by one agency is likely to lead to four additional investigations.
It is important to classify independent contractors and employees properly at the beginning of the working relationship, and fortunately there are tools and resources that can help in making the determination. For help in making sure you are properly classifying independent contractors and employees reach out to a good tax attorney for assistance.
B. Cory Lee received his J.D. from the University of Missouri and his LLM in Taxation from the University of Florida. Cory focuses his practice on tax law, including tax planning, tax controversy, as well as business law matters, contracts and real estate disputes.