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Does your organization employ a lot of independent contractors? Relying on contractors rather than employees is a hallmark of the “gig economy,” and many companies benefit from the arrangement. However, the question of whether a worker is actually an independent contractor, as opposed to a statutory employee, is a legal one.

The difference is important. Employees receive employer contributions toward their payroll taxes, along with workers’ compensation and unemployment insurance, other benefits, and protection under state and federal employment and labor laws. For the most part, contractors are only entitled to what they contract for.

While proper worker classification is often determined by the U.S. Department of Labor Wage and Hour Division, misclassification is also an issue the IRS is interested in. This is because misclassification of a statutory employee as an independent contractor can create tax issues.

Misclassification of an employee as an independent contractor can mean you have:

  • Underpaid wages
  • Missed required overtime pay
  • Underpaid state and federal income and payroll taxes
  • Violated tax requirements by failing to provide W-2s
  • Failed to record the worker’s time correctly
  • Failed to comply with the Affordable Care Act
  • Neglected required workers’ comp and unemployment insurance premiums

At the very least, you could be liable for all the unpaid payroll taxes owed to the IRS, such as Social Security and Medicare contributions. If the IRS finds that you had no reasonable basis for the misclassification, you could be barred from receiving relief from those taxes and could face penalties and interest, as well.

IRS test for employees vs. independent contractors

How does the government decide whether a worker is an employee or a contractor? The IRS and the DOL use slightly different frameworks for that determination, but the main question is how much control the company exercises vs. how much independence the contractor exerts.

The IRS weighs three categories of factors to gauge control vs. independence and makes its ultimate determination based on the totality of the circumstances. The categories are:

Behavioral: How much does the company control the details of the work? Is the worker told precisely how, during what hours and under what conditions the work is to be performed?

Financial: Who controls the financial aspects of the job? Who provides the tools and supplies? Are expenses reimbursed? Does the worker bill the company?

Type of relationship: What type of contract is there? Does the worker receive benefits like health insurance, paid time off or vacation? Is it an ongoing relationship or a single project? Is the work central to the company’s business?

If you are hiring independent contractors, it’s important to know whether you have classified them correctly. An experienced employment law attorney can help.