Contract Labor v. Employee Status: Are you correctly classifying your workers?

Worker classification is an issue that seems to pop up on the IRS’s radar every few years, and it appears that the IRS is once again focusing resources on making sure that you are classifying your workers appropriately.

The issue is this: if you classify your workers as independent contractors, then you shift the payroll tax burden to those workers, a money saver for you.  This classification offers yet another way to save money on your staff, because you would not typically offer fringe benefits to your contract labor. On the flip side, independent contractors have a greater ability to deduct work-related expenses and a broader choice of retirement plan options.

So win-win, right? Well, not for taxing authorities- and this is where potential problems lie. The IRS notes that the worker classification rules are an area of significant taxpayer abuse that results in significant unpaid payroll taxes. This abuse is among the largest contributors to the nation’s tax gap, the difference between what the government should collect and what it actually does collect.

In order to narrow this gap, the IRS stands a much better chance of collecting additional revenue from established businesses instead of chasing down countless independent contractors. So you, as the business owner, are the target of IRS scrutiny on this issue, not your workers.

So what do you need to know in order to minimize your audit risk? First, you need to know the rules. While the IRS does not provide a bright line test, it does provide general guidance. Here is the broad criteria by which the IRS judges worker classification:

  •  Behavioral control – The degree to which you exert control over the performance of the worker. The greater the control a business exerts over a worker, the more likely that worker is an employee.
  • Financial control – Whether a worker can make additional income by integrating more efficient processes and controlling costs. If a worker’s income is independent of other financial measures, then that worker is likely an employee.
  • Relationship of the parties – Whether the working relationship is temporary or permanent and if the worker performs services for multiple parties or just one. Ongoing work status performed for a single party  suggests an employment relationship.

The challenge occurs when some factors tilt in favor of contractor status when others lean towards employee status. Just remember that the IRS has a built-in bias to classify all of your workers as employees, and so independent contractor status must be well reasoned and preferably documented in a policy manual in order to prevail in an IRS examination.