Question:

One of my co-workers was laid off and then re-hired as an independent contractor to do almost exactly the same job. My co-worker gets no benefits now. Can the company do this? I thought that the IRS was cracking down on this sort of thing.

Answer:

The IRS may soon come knocking on your company’s door. For years now, the IRS has identified the misclassification of employees as contractors as a major source of lost tax revenue. This August the IRS issued a new report outlining aggressive new measures aimed at closing the “tax gap.” Although it appears that the primary enforcement focus of the IRS may be self-employed workers who fail to report their income, we also anticipate a crackdown on companies that misclassify employees as independent contractors.

Generally, a three-part common law test is used to determine the difference between employees and independent contractors. The test can be found in Publication 15-A on the IRS website at www.irs.gov/pub/irs-pdf/p15a.pdf. Briefly, there are three main areas that the IRS looks at: behavioral control, financial control, and the type of relationship.

A worker is probably an employee if the business has the right to control and direct when, where, and how the work is done. A worker who uses company equipment is probably an employee. A contractor, on the other hand, typically delivers an end product, without being told who to hire or how to do the job.

The IRS also analyzes the business and financial structure of the contractor’s “business.” For example, a contractor usually offers similar services to several clients. A contractor also typically would be expected to incur significant business expenses, as well as potential losses and profits other than salary. Also, in many professions a contractor is paid by the job, not by the hour.

Lastly, the IRS examines the type of working relationship. Is there a contract for the scope of work being done? Although a contract may state that the worker is a contractor, if under common law an employee-employer relationship exists, it does not matter how the parties characterize their relationship. Is the relationship long-term? This would indicate an employee-employer relationship. Is the job integral to the principal business? If so, it is more likely that the company will reserve the right to control and direct the worker’s activities.

The tax payroll deduction differences between employees and contractors are substantial. Employers are required to withhold Social Security, Medicare, federal and state income tax for their employees. They also are required to withhold federal and state unemployment taxes. An employer is not required to withhold any of these taxes for its contractors.

The failure to withhold may result in unpleasant surprises for workers who have been misclassified by their employers as contractors. For instance, contractors who are injured on the job are not covered by the employer’s worker’s compensation insurance. Also, new “contractors” may underestimate the amount of tax they need to pay, and at tax time they may be confronted with a large tax bill that they are not able to pay.

Employers can also face significant liability for misclassifying an employee as an independent contractor. For example, the employer may be liable for unpaid taxes, penalties, and violations of wage and hour laws including overtime.

If your co-worker thinks she should be classified as an employee, she can file IRS form SS-8 for a determination of her employment status. However, a worker who submits this form puts the IRS on notice that further investigation may be required, and she may be assuming the role of “whistle-blower.”

Starting next year, a worker who believes she should be classified as an employee can also file the new form 8919, currently in draft form. This form allows the worker to save herself the matching Social Security and Medicare taxes that the employer would normally pay on employee wages.

Based on an analysis of the IRS factors, your co-worker may or may not be misclassified.
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