June 8, 2015

audit for independent contractor misclassification“Can I just classify this person as an independent contractor and issue a 1099? It’s so much easier than doing all of that paperwork! What’s the big deal?” If you have found yourself having thoughts like this, keep reading.

Misclassification of a worker as an independent contractor IS a big deal. When the IRS or U.S. Department of Labor steps in to reclassify a worker as an employee, employers can be responsible for fines, penalties, back wages, back taxes, and even, ultimately, litigation.

The risk of a misclassification being discovered is high. Any number of issues could trigger an investigation, including tax issues, unemployment investigations, wage and hour claims, and I-9 form problems. If one misclassification is found, an extensive audit of your files will almost certainly be conducted, and a misclassification of one person will mean misclassification for all those in that position.

IRS audits of small businesses have more than doubled over the past several years. After one recent investigation, the Wage & Hour Division of the U.S. Department of Labor sued three small Texas medical service companies, seeking $142,000.00 in back taxes and wages after finding that the companies had misclassified employees as independent contractors.

So, the one-hundred-forty-two-thousand-dollar-question is: How do you know when to classify a worker as an independent contractor?

The answer to this is tricky because the IRS uses a multi-factor test. The results of this test will vary depending on the situation and the laws in your state. For example, Illinois and Massachusetts have the strictest misclassification criteria in the nation.

The ultimate determination as to whether a worker is an independent contractor generally hinges on how much control the employer has over that worker. The considerations for control fall into three categories:

  1. Behavioral Control: Do you as the employer have control over what the worker does and how they do their job?
  2. Financial Control: Do you as the employer have control over things like when and how the worker is paid? Over what expenses they accrue? Do you provide the tools and equipment they need for their job?
  3. Type of Relationship: Do you have a written contract with the worker? Do you offer the worker benefits, such as vacation pay, insurance, pension plan? Will the relationship automatically continue from year to year, or is there a set end date?

The big thing to keep in mind is that workers should never automatically be classified as an independent contractor. Use CEDR’s Independent Contractor Cheat Sheet to assist your analysis, and be sure to call the CEDR Solution Center for more guidance and information on your state laws.

When making the independent contractor determination, consider the following Do’s and Don’ts:

DO:

  • Have a well-written agreement if you classify a worker as an independent contractor. The agreement should specify the end result of a project. It should not simply be a contract for the worker’s time.
  • Conduct an annual internal audit for all workers you have classified as independent contractors. Even employment relationships that start out correctly classifying a worker as an independent contractor could run afoul of the law. Relationships change over time, and it is essential that you remain vigilant.
  • Proceed with caution if you are considering engaging a former employees as independent contractors.

DON’T:

  • Categorize someone as a contractor who will do similar work under the same conditions as your employees. For example, if you practice general dentistry and you hire an associate dentist to assist with general dentistry, the associate would be properly categorized as an employee.
  • Engage a worker as a contractor who is or has been employed by you in the last 18 months. This is a red flag to the IRS and almost certainly will lead to an audit.

We can’t stress enough the importance of getting employee classification right in your office. If you have questions about this trainer or want to know more about fixing a possible misclassification before it comes back to bite you, one of our in-house HR experts will be happy to help. Just call (866) 414-6056 or submit your question to info@cedrsolutions.com.

Friendly Disclaimer: This information is general in nature and is not intended to provide legal advice or replace individual guidance about a specific issue with an attorney or HR expert. The information on this page is general human resources guidance that is believed to be current as of the date of publication. Note that CEDR is not a law firm, and as the law is always changing, you should consult with a qualified attorney or HR expert who is familiar with all of the facts of your situation before making a decision about any human resources or employment law matter.