Use Care in Classifying Employees as Independent Contractors
Thomas W. Hartmann
The Hartmann Law Firm LLC
TheHartmannLawFirm.com; [email protected]; 908 769 6888
When you run a business, you engage people to help you sustain and grow it. Sometimes you hire employees; sometimes you bring on consultants or independent contractors. While we sometimes think it is less expensive to hire a contractor in order to save on various tax and benefit expenses, the issue is far more complex than cost savings. If a company designates someone as a contractor but treats the person as an employee, the negative consequences will far exceed the intended cost savings in terms of back pay, penalties, and lost productivity.
Employees versus Independent Contractors.
For employees, company must not only pay the salary or hourly wage rate, but must withhold income taxes, withhold and pay Social Security (FICA) and Medicare taxes, and possibly pay unemployment compensation upon the departure of the person.
With independent contractors, the company pays only the agreed amount set forth in the contract. The independent contractor is just that – independent and a contractor. He is not part of the company.
As a result, companies may be tempted to treat people who would normally be considered employees as independent contractors. But this is not a “saving money” issue. It is a legal, employment and tax issue with huge consequences.
The IRS Test.
In determining whether someone is an employee or an independent contractor, the Internal Revenue Service looks at a 20 part test, which focuses largely on the level of control the employing company has over the employee or consultant. The more control the company has, the more likely the person is an employee.
For example, does the company provide tools for the person rather than requiring the person to supply his own? Does the company dictate hours of work? Does it specify exactly how the work is to be done? Is the employee or contractor doing the kind of work that the company does? What does the person's business card say? Does the person have a permanent office inside the company? Does the person have his or her own business? Does the person have customers beyond the company in question? Is a contract in place that spells out the status of the person and specifies that he is being treated as an independent contractor and not as an employee? While the last question is not a “factor,” it may be a useful tool in helping the company show its analysis on the matter, if ever challenged.
New Jersey imposes an additional three part test that includes the following factors: (1) what is the level of control or direction over the person; (2) is the work being done outside the kind of work the company typically performs or performed at another place; and (3) does the person have an independent business through which he is performing the services?
If the IRS or the State challenges a classification, you will have to undergo an employment audit. Knowing this, you are wise to undertake an internal audit on your own each time you decide to engage an independent contractor for a particular service.
The Cost of an Error.
This is because the consequences of being wrong can be significant, with tax withholding calculated at 1.5 to 3.0 percent of the wages of the employee and FICA liability at 20-40% of what the employee should have paid plus 100 percent of the employer's share. There are additional penalties for failure to have paid the unemployment taxes. Still other penalties can be piled on if the reviewing agency determines that there was no reasonable basis for the company to have treated the person as an independent contractor.
Avoiding the Error.
On the other hand, if the employer acted reasonably, researched the matter, and sought professional guidance before acting, the penalties can be avoided or mitigated. The IRS will assess whether the employer ever treated the person as an employee; filed tax returns always showing the person as an independent contractor; and treats similarly situated people the same. Additionally, the IRS will examine how other companies in the industry treat this situation.
The proper classification of employees is critical. While a quick judgment to identify someone as an independent contractor might seem like an excellent economic move in difficult times, if the issue is not carefully reviewed by legal, accounting and human resources staff, an improper classification can bring on an audit and far more treacherous results.
The Hartmann Law Firm LLC can assist in these compliance matters to insure your business and your assets are protected. Beyond this, we can help guide businesses through issues ahead of litigation or aggressively advocate in litigation and business disputes should the need arise.