During National Small Business Week, the Internal Revenue Service (IRS) issued a notice reminding business owners to correctly identify workers as employees or independent contractors. The notice explained the three-factor test used to classify employees and independent contractors and the consequences of misclassification.
Classification of Workers as Independent Contractors Versus Employees
In Notice IR-2021-186, issued on September 15, 2021, the IRS referenced its three-factor worker classification test. To determine whether a worker is an employee or an independent contractor, consideration must be given to all facts and circumstances that provide evidence of the employer's degree of control and the worker's independence. A worker generally is considered an employee if the company controls the method and manner of the services performed.
In evaluating a company's degree of control over a worker, the IRS examines the following three categories: (1) behavioral control; (2) financial control; and (3) relationship of the parties. A company has behavioral control over a worker if it has the right to control what the worker does and how the worker performs the job. Generally, if a company has the right to control or direct only the result of the work performed, then the worker is considered to be an independent contractor. If a worker receives extensive instruction on how their work is to be performed, that suggests that the worker is an employee. Instructions may be given on a wide range of areas, such as how and when to do the work, who the worker may hire to assist with the work, and what tools to use to perform the work. Similarly, if a worker receives training on specific procedures required to perform the work, that provides further evidence that they may be an employee.
A company has financial control over a worker if it directs or controls the financial and business aspects of the worker's job. Financial control includes the extent to which the worker is reimbursed for expenses and how the company pays the worker. If a worker is not reimbursed for business expenses, can realize a significant profit or incur a loss, and has a substantial monetary investment in the work, that worker might be considered an independent contractor.
The third category of the three-factor test requires evaluation of such questions as whether there is a written contract describing the relationship the parties intend to create, whether the employer offers benefits such as a pension and vacation time, the permanency of the relationship, and whether the work performed is a key aspect of the company's business.
Companies must consider all three categories to determine whether a worker is an independent contractor or an employee, and no one factor weighs more heavily in making this determination. Careful and holistic evaluation of the extent of the direction and control over each worker allows for correct classification of independent contractors and employees. If the three categories of evidence do not clearly delineate whether someone is an employee or independent contractor, a Form SS-8 may be filled out and reviewed by the IRS. The IRS will assess the relevant facts and circumstances to determine the worker's status.
Differences Between Independent Contractors and Employees
For employees, employers must withhold the employee's income tax and portion of Social Security and Medicare taxes. In addition, employers are responsible for paying Social Security, Medicare, and unemployment taxes on employees' wages. Employers use Form W-2, Wage and Tax Statement, to report wages and other compensation paid to employees.
On the other hand, companies use Form 1099-MISC, Miscellaneous Income, to report payments made to independent contractors. If a worker is an independent contractor, then s/he is considered to be self-employed. The earnings of independent contractors are subject to self-employment tax under the Self-Employment Contributions Act and to income tax. This means that businesses do not withhold taxes from independent contractors' pay.
Consequences of Misclassification
Classification affects workers' tax responsibilities and eligibility for benefits. Misclassifying employees as independent contractors results in employers not paying their share of taxes and other employment-related expenses. Companies face a risk of misclassification when they provide contractors with training, workspaces, and responsibilities identical to those they provide employees, without extending the same employee benefits, such as minimum wage, overtime pay, healthcare, and workers' compensation, to the contractors.
If an employer misclassifies an employee as an independent contractor with no reasonable basis, it may be held liable for employment taxes for that worker. Employers that misclassify workers may face penalties for each Form W-2 that the employer failed to file and penalties for the income taxes, Social Security, and Medicare taxes that were not withheld. If the IRS suspects fraudulent or intentional misclassification, it can impose additional fines and criminal penalties. The Voluntary Classification Settlement Program is an optional program that allows eligible taxpayers to reclassify their workers as employees for future tax periods with partial relief from employment taxes.
Employers are encouraged to keep an eye out for more in-depth discussions by Venable attorneys on other important developments. Employers are also encouraged to contact one of Venable's experienced Labor and Employment attorneys with questions regarding classification of workers as independent contractors or employees. Please feel free to reach out to us to discuss how our attorneys can help you ensure compliance across your hiring and employment practices.