Independent Contractor or Employee? Ask These 5 Questions Before You Decide

The IRS audited over 2 million small businesses last year. One of the first things that they look at is how you are classifying your workers. If you have 1099 contractors on payroll, stay with me. This could save you thousands. First, let's clear something up. The label on the contract does not matter. A lot of business owners seem to think that you have a signed contractor agreement, that settles it. Well, it doesn't. IRS and the Department of Labor actually look for what is the nature of the working relationship. Ultimately, courts have ruled against employers with signed contractor agreements in hand because they were treating those contractors just like employees. If you've been operating under the assumption that 1099 form is all the protection that you need, that assumption is worth revisiting. So how do you know if someone should be classified as an employee versus a contractor? Well, the IRS uses a 3-part test that identifies behavioral control, financial control, and the type of relationship. The Department of Labor uses a test called an economic reality test. Slightly different questions, but ultimately they're trying to ask the same thing. Who controls the work that gets done? So here are the key questions that you should be asking of each of your contractors. Does your business control how the work gets done? Not just the end result. Do you set the hours or require them to work on site? Do you provide their tools and equipment? Do they work exclusively for you or do they have engagements with other clients? And is the relationship ongoing and indefinite, or is it project-based and have clear end dates? The more of these questions that you're answering yes to on the employer side, the more the relationship ultimately sounds like employment, regardless of whatever you have signed. All right, so here's where it gets expensive. The worker is reclassified as an employee, you as the employer can be on the hook for the employer and the employee side of FICA taxes. Basically, you're on the hook for the payroll taxes that should have been withheld, plus any interest and penalties that may have come along with that. Beyond federal exposure, many states have their own misclassification penalties layered on top of that. Classified worker has the right to file retroactive claims for overtime that they weren't paid, benefits that they weren't offered, or workers' comp coverage that they weren't provided. It's not a paperwork problem, it's a financial exposure problem, and it compounds the longer that it goes unaddressed. The good news is that the classification audit is not overly complicated, and doing it proactively is far cheaper than responding to an IRS inquiry. Start by listing every active contractor that you have on payroll. Then run each of those contractors through the control questions that we just asked. Flag anyone where the answers start seeming like they're leaning toward employment rather than independent work. For the gray area relationships, and there will be some, you may want to bring in an HR or payroll professional to help make the call. Catching this on your own terms is far better than catching it it on the IRS's terms. The IRS doesn't audit your intentions, they audit the relationship. If you control how the work gets done, chances are you have an employee regardless of whatever the contract says. If you have contractors and you're not sure if they're classified correctly, reach out to us at Guru. This is exactly the type of audit that we help clients with to address this before it becomes an issue. Like and subscribe and follow for more payroll and HR updates. We'll see you in the next one.