Many small employers find themselves in need of additional help as business gradually recovers. For some industries the thought may be raised as to whether hire a new employee or hire an independent contractor.
When employees are hired, the cost to the employer is more than the hourly rate or salary promised to the new hire. Benefits can be impacted as well as payroll taxes. Due to these additional costs, it may seem smart to hire an independent contractor to fill the duties and thus avoid increases in the costs of benefits and taxes. Before heading down this avenue, it is important to know and properly apply the 20-factor test the internal revenue service uses to classify independent contractors and employees.
The proper classification of independent contractors and employees is a major concern of the Department of Labor and the IRS. When employees are misclassified, these two agencies are asserting thousands of tax dollars could be unpaid for each misclassified worker. For employees, employers are responsible for paying state and federal unemployment taxes, withholding social security and Medicare taxes, pay the employer’s share of these taxes, and withhold and remit federal income taxes on behalf of the employee. When contractors are hired, none of these costs or responsibilities fall on the shoulders of the employer. It is the agencies opinion that if there were fewer misclassifications far more tax dollars would be collected and remitted by employers. As a result, there are a number of bills being introduced in Congress this year to make it tougher to classify independent contractors and would impose harsher penalties for those employers who violate this rule.
The IRS has a publication covering this topic, number 1779, “Independent Contractor or Employee.” I was surprised by the simplicity of this particular publication. It covers the 20-factors by dividing them between Behavioral Control, Financial Control, and Relationship of the Parties. Due to the infinite number of relationships, jobs, and circumstances which may exist between an employer and a worker, this publication does not provide the definitive answer an employer make want. More than five boxes checked, then the worker is an employee. It does provide the definitions and guidance such that a proper conclusion should be able to be drawn.
Employers and reader may wonder why this is such an issue. It is because the penalties that could be accessed by the IRS could become so large as to financially cripple the business. When an employee is misclassified as an independent contractor, then every state unemployment report and federal employment report now has an error due to the underreporting of tax and or wages. Since many of these reports are quarterly, and penalties can be accessed for each report, the amounts can add up quickly. And it is not just the penalties, but it can also be the tax that may be required to be remitted even though it was not deducted from the payments to the employee. Errors in this area can become very messy and expensive very quickly. Far greater than the potential savings by classifying someone as a contractor when they are really an employee.
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