Tax advantages

Businesses often prefer to classify workers as independent contractors. Employers are obligated to pay the employer portion of FICA taxes for employees, but not for independent contractors. They also must withhold income taxes from employee pay, but not from independent contractor compensation.

There are many other obligations associated with employees that make independent contractors appealing to businesses. But these two tax obligations draw the attention of tax authorities.

Useful questions

IRS guidelines say that no single factor typically determines whether a worker should be classified as an employee or independent contractor. Instead, the decision hinges on an “economic realities” test that attempts to distinguish workers who are economically dependent on an employer — and are thus employees — from those in business for themselves and therefore not economically dependent.

The following questions can help you determine a worker’s status:

Is the work performed by the worker an integral part of your business? The more integral the work, the more likely the worker is economically dependent on you and is an employee. The work can be considered integral even if it’s one step in a process, performed by multiple people or performed away from your place of business. For instance, most carpenters perform work integral to a construction company, even though they typically work outside the business’s office.

Does the worker’s opportunity for profit or loss depend on his or her managerial skill?  A key word here is “managerial.” An independent contractor demonstrates managerial skill by, for example, deciding whether to hire employees or purchase equipment. A worker in business for him- or herself also faces the possibility of a financial loss.

Has the worker “invested” in the work? A truly independent contractor will invest in his or her business, and the investment will go beyond simply purchasing tools needed to do the job.

What role do the worker’s skills and initiative play? Just because workers are technically proficient at a task — say, installing and repairing cable services — it doesn’t mean they’re independent contractors. However, skilled workers who demonstrate initiative to operate as an independent business may be. Operating as an independent business generally means that the worker exercises business judgment, is in open market competition with other businesses and isn’t economically dependent on an employer.

Is the relationship between the worker and your company permanent or indefinite? Many at-will employees are considered permanent or indefinitely employed — rather than employed on a project or contract basis.

What is the nature and degree of your control vs. the worker’s? A truly independent contractor will exert control over a meaningful part of the work and relationship with an employer. Indeed, it’s almost impossible for companies — due to client demands or regulations — to prevent contractors from exerting control over the work and relationship.

Possible penalties

The question of proper classification becomes urgent for employers in light of potentially harsh tax penalties associated with misclassification. Costs can be steep and may include back taxes and interest. When in doubt, consult your financial advisor for expert advice to help you make the correct call.

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