Employee misclassification penalties and how to avoid them
If you use independent contractors or freelance workers on a day-to-day basis, the Internal Revenue Service (IRS) may be interested in how you classify them. Are they really independent contractors or do they actually perform their duties as if they were an employee? Classification determines how your workers are paid, their level of independence, and other important factors.
Employee misclassification penalties can be quite severe if your company becomes the target of an IRS audit, even if it’s just an honest mistake. Don’t worry; compliance can be complex. We’ll explain how employees and other types of workers are classified, which can be helpful background information as you work on your company’s compliance.
Worker classification basics
The two main types of worker classification determine how workers are scheduled, paid, and (in many cases) managed. These are:
- Exempt vs. non-exempt – Certain workers, particularly those in a management role, are exempt from overtime rules. Non-exempt workers typically include those paid on an hourly basis (as opposed to an annual salary).
- Independent contractor vs. employee – The term “employee” suggests a specific relationship with an employer. An independent contractor, however, should have the final say in their work product and how much it’s worth.
For the purposes of this article, we’ll focus on the classification of independent contractors versus that of employees, since it has tax implications (whereas failure to properly classify a non-exempt employee can lead to legal action). Employers must withhold taxes for their employees, while independent contractors must set aside and pay taxes themselves.
Are they an independent contractor or an employee?
The best way to avoid employee misclassification penalties is, of course, to properly classify them in the first place. The IRS considers evidence falling into three categories to determine this:
- Behavioral control – Does the business/employer have the right to direct and control the work through training, instructions, etc.? For instance an independent contractor can’t be required to work on the contracting company’s premises or within certain hours.
- Financial control – Does the business/employer have the right to direct and control the financial and business aspects of their job? This may include the extent to which the worker has unreimbursed expenses, investment in the tools used to do the work, how the worker is paid, and so on.
- Relationship to the parties – Was there a written contract establishing the nature of the relationship? Does the business provide any employee-type benefits? Are the services provided by the worker a key aspect of the company’s regular business?
Generally, a worker will be considered an independent contractor as long as they don’t rely on your business as their sole source of income, work at their own pace (or in accordance with an agreement), aren’t provided with benefits, and retain a degree of independence.
Employee misclassification: penalties and consequences
Companies determined to have misclassified employees as independent contractors are liable for employment taxes. If the IRS makes this determination, you may be able to avoid these taxes if you’re able to provide a reasonable basis for classifying them as independent contractors. If you find yourself in this situation, reaching out to your corporate counsel is a must.
Also, certain eligible businesses may have the option to reclassify their workers voluntarily and thus receive partial relief from federal employment taxes. But if you fail to take action, you could be opening yourself up to a surprise tax bill. So it pays be proactive.
Whether you need independent contractors or employees, let Monster help you find the best
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Legal Disclaimer: None of the information provided herein constitutes legal advice on behalf of Monster.