Classifying employees the right way

By Leah Powell, Principal, The Bonadio Group 

Do you have any independent contractors working for you?

If so, please note that the IRS is increasing its focus on worker classification. The consequences of misclassifying workers are significant to the worker, the employer, and governmental agencies. Misclassifying contractors or even temporary laborers that the IRS feels should be treated as employees can cost you big dollars in payroll taxes, penalties, and interest.

Upcoming IRS Audits Focusing on Worker Classification

Beginning in February, 2010, the IRS is launching an examination of 6,000 randomly selected companies to focus on employment tax issues ranging from executive compensation to fringe benefits. The IRS will perform an examination of 2,000 random companies per year over the next three years. Companies targeted will be of varying sizes and include both for profit and non-profit employers. While these audits can target any reporting aspect of the tax return the IRS's primary focus will be on worker classification, executive compensation, fringe benefits, nonfilers and reimbursed expenses.

Hiring people as independent contractors vs. employees has a significant financial impact for both employers and workers. The classification of workers as independent contractors relieves employers from withholding federal income and payroll taxes, paying the employer's share of FICA taxes on the wages plus FUTA tax, and often providing the worker with fringe benefits such as health insurance and overtime pay. There may be state tax obligations as well. From a financial perspective, it is certainly appealing to try to build a case for classifying workers as independent contractors. However employers should consider the possible payroll tax (and penalty) ramifications should they not be able to support their employment classifications upon examination.

Keep in mind that the IRS isn't the only one interested in how workers are classified.

The IRS has come out with a new form in 2009 (Form 8919, Uncollected Social Security and Medicare Tax on Wages) allowing workers who feel they were misclassified as independent contractors to report their share of uncollected social security and Medicare taxes due on their compensation. They would pay their half of the uncollected social security and Medicare tax with their personal return (as opposed to the full SE tax) and the IRS would likely come knocking on businesses doors for the other half!

So who is an "employee" for purposes of employment classification purposes ?

The classification of an employee vs. an independent contractor is not easily defined and is subject to a facts and circumstances analysis. However, the IRS has a 160 page internal training guide for its agents to help classify workers. While initially drafted in October 1996, it is still being used by agents today and will likely see increased use in their upcoming examinations.

Per this guide, a worker is an employee if he or she is a common law employee, corporate officer, statutory employee, or employee covered by agreement under section 218 of the Social Security Act. Under common law the treatment of a worker as an independent contractor or employee depends on whether the employer has the right to direct and control the work of the worker.

The IRS looks to three categories of evidencing in determining whether there is a right to direct and control a worker:

Behavioral control - who has the right to direct or control how the worker performs a task such as when and where to do the work, what tools or equipment to use, how to accomplish the task at hand, etc.

Financial control - who has the financial control of activities undertaken, is any significant investment required by the worker, who bears the cost of business expenses, is payment for services guaranteed or paid on an hourly basis or flat fee basis, does the worker have opportunity for profit or loss, etc.

Relationship of the parties - what is the intent of the parties, is there a written, contractual agreement, are there employee benefits (paid vacation, participation in tax-qualified retirement plans, etc.), what are the discharge or termination policies concerning the worker, is the work done by the worker integral to the employer's business that can't easily be done by others?

Are you comfortable in your worker classification abilities?

Now would be a good time to proactively review your company's current payroll procedures and seek outside expertise regarding the targeted tax areas, if necessary.

About the author:

Leah Powell is a Principal with the tax team in the Rochester office of the New York-based The Bonadio Group.  You can reach Leah at or (585) 381-1000.

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