If your business is improperly treating workers as self-employed—that is, as independent contractors—expect trouble if the IRS calls. The IRS has the power to change the classification of any worker, with expensive consequences for the business owner.

By calling workers “independent contractors,” business owners avoid burdensome tax reporting, bookkeeping, and withholding taxes from their workers’ paychecks. Moreover, entrepreneurs dodge the tax expense of matching employees’ FICA contributions and paying the unemployment tax. The tax savings and reduced paperwork of improperly calling employees independent contractors can be significant—unless you get caught. Violators can be penalized up to 35% of the payments made to the wrongly classified worker, plus interest. 

In any event, a business must annually report to the IRS amounts paid to true independent contractors as well as employees. Within one month after the end of each calendar year, owners must file Form 1099 for each independent contractor paid more than $600. Owners must also send a copy of Form 1099 to the contractor.

If the IRS finds that you failed to issue a Form 1099, you may be hit with a separate penalty. (Internal Revenue Code § 3509.) Plus, it bolsters the IRS’s case that you misclassified the worker.

Misclassification of independent contractors is an IRS priority. The IRS has targeted for audit businesses suspected of wrongly classifying workers, such as building contractors, medical professionals, graphic designers, and neighborhood beauty shops, to name a few. 

IRS and state auditors can assess an employer not only the payroll taxes that should have been collected and paid, but also the reclassified employee’s unpaid income taxes. And as the penalties and interest mount, businesses can receive audit bills of 50% or more of wages paid. For example, if you paid Millie Ways, an employee, $20,000 as an independent contractor, the IRS might hit you with $10,000 in taxes, penalties, and interest for the misclassification.

How to Classify a Worker

To determine worker classification from the IRS point of view, see Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding. (See the IRS’s website at www.irs.gov ) Here is a summary of the SS-8 factors, gleaned mostly from court decisions.

Factors Tending to Show the Worker Is an Employee of Your Business 

  • You require—or can require—the worker to comply with your instructions about when, where, and how to work.
  • You train the worker to perform services in a particular manner. You integrate the worker’s services into your business operations.
  • You require the worker to render services personally; the worker can’t hire others to do some of the work.
  • You hire, supervise, and pay assistants for the worker.
  • Your business has a continuing relationship with the worker or work is performed at frequently recurring intervals.
  • You establish set hours of work.
  • You require the worker to devote the majority of the work week to your business.
  • You have the worker do the work on your premises.
  • You require the worker to do the work in a sequence that you set.
  • You require the worker to submit regular oral or written reports.
  • You pay the worker by the hour, week, or month, unless these are installment payments of a lump sum agreed to for a job.
  • You pay the worker’s business or traveling expenses.
  • You furnish significant tools, equipment, and materials.
  • You have the right to discharge the worker at will and the worker has the right to quit at will.

Factors Tending to Show the Worker Is an Independent Contractor

  • The worker hires, supervises, and pays her assistants.
  • The worker is free to work when and for whom she chooses.
  • The worker does the work at her own office or shop. The worker is paid by the job or receives a straight commission.
  • The worker invests in facilities used in performing services, such as renting an office.
  • The worker can realize a profit or suffer a loss from her services, such as a worker who is responsible for paying salaries to her own employees.
  • The worker performs services for several businesses at one time—although sometimes a worker can be an employee of several businesses.
  • The worker makes her services available to the general public.
  • The worker can’t be fired so long as she meets the contract specifications.

People Who Are Automatically Employees by Law

In most situations, the status of a worker is determined by the above-listed factors. Certain workers fall into special tax categories, and the usual IRS criteria don’t apply. Workers who are automatically employees include:

  • Officers of corporations who provide service to the corporation
  • food and laundry drivers
  • full-time salespeople who sell goods for resale
  • full-time life insurance agents working mainly for one company, and
  • at-home workers who are supplied with material and given specifications for work to be performed

Exempt Employees and Small Business Owners 

The tax code states that licensed real estate agents and door-to-door salespeople are tax-classified as non-employees or exempt employees. They may be treated as regular employees for non-tax purposes, however, such as liability insurance and workers’ compensation. 

Sole proprietors or partners in their own business are neither employees nor independent contractors. They pay their own income tax and Social Security/Medicare self-employment tax. But a shareholder in his incorporated business is legally an employee of his corporation in most cases

How Independent Contractor Rules Are Applied

Let’s look at two workers—one an employee and the other an independent contractor—who provide similar services but fall into different tax classification categories. 

State Rules May Be Different IRS classification rules are similar to those of most states for state taxes and unemployment rules, but there are differences. For example, in California, a person working for a licensed contractor who performs services requiring certain state licenses is classified as an employee unless he, too, has a valid contractor’s license. If you plan to hire independent contractors, check the law in your state to see if there are special rules in effect.

Example 1—Employee

Wendy Wordsmith teaches marketing at a community college. Wendy also works part-time for ABC Enterprises writing ads, catalogs, and consumer information leaflets. Wendy works every Wednesday at ABC’s offices, receiving a $200 salary each week. Wendy receives direct supervision and instructions from the owner. Wendy occasionally does some work at home when required to by ABC and is not allowed to do this kind of writing for anyone else. Wendy is an employee of both ABC Enterprises and the college.

Example 2—Independent contractor

XYZ Distributors has similar needs for writing on an occasional basis. But when XYZ needs a newspaper ad or catalog produced, it calls upon Frank Freelance. Frank always works out of his home and frequently hires assistants whom he pays directly. Frank pays all his own expenses. Each time he completes a job for XYZ, he sends the company an invoice. Frank is not prohibited from writing ads for other businesses. He clearly is an independent contractor and not an employee of XYZ.

Example 3—Part Time Workers

ffJohn operates a desktop publishing shop specializing in writing and designing brochures, flyers, and other promotional materials for small businesses. At the start, John does most of the work himself, turning any overload over to others, including Sue, Ted, and Ellen, all working out of their homes. John collects from the customer and pays these people as independent contractors. So far, so good. But as John’s business grows, he brings Sue, Ted, and Ellen into his office to work part-time under his broad supervision, an average of about one or two days per week each. The rest of the time they work for themselves. John continues to treat them as independent contractors. By law, he shouldn’t. If he continues along this line, he’s tempting fate—and the IRS. John is exercising significant control over these workers and using their services in-house on a regular basis. Under the IRS guidelines, they are all employees, even if they are regularly employed elsewhere. 

How Business Owners Can Protect Themselves

Here’s how to prove a worker was an independent contractor if you are audited: 

  • Enter into a written contract with the independent contractor. Spell out the responsibilities of each party and how payment is to be determined for each job. The contract should allow the independent contractor to hire his or her own assistants.
  • Require the independent contractor to furnish the tools, equipment, and material needed for the job.
  • Have the independent contractor do all or most of the work at his or her own place—not at yours.
  • Make it clear that the independent contractor is free to offer services to other businesses besides yours.
  • Pay for work by the job rather than by the hour, week, or month. Require the independent contractor to submit invoices for each job before you make payment.
  • Require the contractor to show proof of a business license and insurance.
  • Require the worker to prove she is reporting what you pay her on her tax return.

The IRS invites businesses or workers to submit Form SS-8 for an IRS analysis of whether or not a particular worker qualifies as an independent contractor. I don’t suggest using this form because it will alert the IRS to the issue. Instead, consult a tax professional.

Employee Vs. Contractor