“Why do I need to worry about proper classification? It’s not my responsibility. I am just a small business owner trying to grow my business……”
Unfortunately, improperly classifying someone as an independent contractor when they are truly an employee can cause some major headaches!
The idea that whether a worker classifies as an independent contractor or employee does not matter is a major misconception. As a business owner, it is important to make sure that worker classifications are correct.
Who is considered an employee? Since no bright line test exists to help make this determination, one must rely on court cases rather than statute, generally referred to as “common-law” rules. In short, these rules state that if an employer has the right to control and direct the worker as to how the work is performed, the worker will likely be classified as an employee. For example, does the employer require the worker to report to work at a specific location and time, provide the tools necessary to complete the work, and/or dictate the procedures used to complete/process the work? If so, this worker is likely an employee rather than an independent contractor.
One motivation for employers to classify a worker as an independent contractor rather than an employee is the avoidance of employee-related expenses. These expenses include the employer’s share of FICA (Social Security and Medicare tax), federal and state unemployment tax, and other employee fringe benefits (e.g. health insurance and retirement plan matching).
What happens if there is a misclassification? The employer may be responsible for both the employer’s and employee’s portion of FICA if the employer cannot prove that the worker paid the correct amount. In addition, the IRS can assess a 1.5% penalty based on total compensation for failure to properly deduct and withhold federal withholding tax, plus a 20% penalty on the employee’s portion of FICA which should have been properly deducted and withheld. These penalties are assessed separately for each misclassification. The 1.5% and 20% penalties can be increased up to 3% and 40%, respectively, if the employer cannot show reasonable cause for failing to file a Form 1099.
The aforementioned penalties are just the tip of the iceberg. Employers may face additional penalties for failure to pay federal and state unemployment insurance as well as the employer shared responsibility penalties with regard to the Affordable Care Act. Separate penalties may also be assessed at the state level for each misclassification.
Navigating through the employment tax system can be daunting, but adequate consideration must be given when deciding who is considered an independent contractor versus an employee. Improperly classifying workers can bring some unwanted consequences to the employer, and purposely misclassifying them will bring double the trouble.