The classification of workers as independent contractors or employees has significant implications — both tax and nontax — for all businesses. But this issue is particularly important for construction companies, given the widespread use of subcontractors in the industry.
The IRS continues to address the issue and crack down on businesses that have allegedly misclassified employees as independent contractors. And the consequences of employee misclassification can be costly in both dollars and bad press. Let’s examine some important points to keep in mind.
Advantages of status
As you’re probably aware, treating a worker as an independent contractor provides significant advantages for a business. You avoid costs associated with withholding and remitting federal income and payroll taxes, as well as paying the employer’s share of payroll taxes. You may also avoid state income tax withholding, unemployment tax, workers’ compensation and disability insurance requirements.
In addition, independent contractor status relieves a company of obligations to:
- Provide employee benefits,
- Pay minimum wages or overtime, and
- Verify a worker’s eligibility to work in the U.S. (by completing Form I-9).
From a worker’s perspective, independent contractor status has historically been regarded as largely disadvantageous because independent contractors are generally ineligible for employee benefits and various employment protections. However, with the rise of the “gig economy” and the advent of “the Great Resignation,” more and more people are opting to become self-employed.
Consequences of misclassification
There’s a widespread misconception that the IRS and state tax authorities won’t challenge the classification of a worker as an independent contractor if the company files Form 1099 and the worker’s tax obligations are met. But the reality is that tax agencies would rather deal with employees than independent contractors because it’s generally easier to collect taxes from a single employer than from many independent contractors.
If the IRS reclassifies an independent contractor as an employee, harsh consequences may follow. You could be held liable for back taxes — including income taxes that should have been withheld, and both the employer and employee shares of payroll taxes — plus penalties and interest. Notably, you can incur penalties even if the worker fulfills the tax obligations of an independent contractor.
In addition to having to pay back taxes, you might also be exposed to claims by misclassified employees for employee benefits, minimum wages or overtime, as well as penalties for failure to meet I-9 requirements.
Issues to evaluate
Whether a worker is properly treated as an employee or independent contractor depends on the facts and circumstances of each case, but certain factors are critical to the determination. The IRS typically examines details within three categories:
- Behavioral control. Generally, the more control the company has over what a worker does, and how and when it’s done, the more likely the worker is an employee. Factors to examine include the level of training and instruction provided, control over when the work is performed, and the existence of performance evaluation mechanisms.
- Financial control. The more control the company has over the economics associated with a worker’s job, the more likely the person is an employee. Employees tend to use their employers’ equipment, get paid based on the number of hours they work, get reimbursed for their expenses, and receive paid time off and other perks. Independent contractors typically have their own equipment, pay their own expenses, and can experience profit or loss on jobs. Often, they’re paid a flat fee rather than an hourly rate.
- Nature of the relationship. Employees are more likely to be hired indefinitely and to work for a single company. Independent contractors are often engaged on a project basis and typically offer their services to multiple customers. Workers entrusted with key business functions are more likely to be considered employees.
Also, be aware that some states have enacted laws that govern the classification of workers.
An ongoing issue
Whether a given individual is an independent contractor or employee is an ongoing issue that has challenged businesses for years. To avoid or minimize liability for back taxes, back wages and penalties, general contractors should regularly reexamine their relationships with subcontractors — especially any used regularly or for long-term projects. We can help you assess whether you’re at risk from the IRS or a state tax authority.
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