Payroll Tax Compliance: Be Careful When Classifying Employees

12/28/2015 - By Zachary Farrington

One way some businesses hold down payroll costs is by assigning substantial amounts of work to third-party service providers rather than employees. But classifying a worker as an independent contractor, rather than an employee, is not just a matter of choice. The rules are complex and subject to interpretation. Moreover, because of the payroll taxes involved, the Internal Revenue Service takes a special interest in seeing that workers are properly classified.

If an audit determines that you have misclassified an employee as an independent contractor, you could face substantial tax bills and penalties.

Making the Determination

For many years the IRS used a list of questions known as the “20 Factor” test to help companies determine worker classification. A few years ago, it consolidated the 20 factors into 11, which it organized into three categories:

1. Behavioral control — How much does the business direct and control how the worker does the job? Some key factors include instructions about when, where and how to work; the order or sequence of work; where materials are purchased; and any training that is provided.

2. Financial control — How much does the business control the business aspects of the job? This includes the extent to which a worker has unreimbursed expenses, whether the worker has any investment in the job other than his or her own time, how the worker is paid, and whether the worker’s services are also offered to other businesses.

3. Type of relationship — How do the two parties perceive their work arrangements? In addition to written contracts, another factor is whether the business provides the worker with employee-type benefits such as insurance, a pension plan, and vacation or sick pay. IRS Publication 15-A, the Employer’s Supplemental Tax Guide, includes several examples of common construction industry scenarios involving the use of independent contractors. Generally speaking,if the company controls both what is to be done and how it is to be done, the workers involved are probably employees. But if the company controls only the result of the work, not the means and methods of accomplishing it, the workers could be outsourced.

Ask the IRS?

In addition to increasing its payroll tax audits, the IRS has taken other steps to encourage businesses to review worker classifications. For example, you or a contract worker can ask the IRS to review the circumstances and make an official determination of the appropriate status — use Form SS-8. Be aware that it can take at least six months to get a decision.

For companies that believe they might have been misclassifying employees for some time, the IRS offers a Voluntary Classification Settlement Program (VCSP). This lets you voluntarily convert your contractors to employees for the future and pay only a nominal amount of back payroll taxes, with no interest or penalties.

VCSP might sound like a good way to address a longstanding misclassification issue, but proceed cautiously – especially if there is any possible doubt about the misclassification.

The IRS, Department of Labor and some state agencies have information-sharing agreements. If you preemptively admit to a misclassification through the VCSP, you could open up other issues including wage and hour compliance under the Federal Labor Standards Act, state and federal unemployment insurance, workers’ compensation insurance, and Immigration Act compliance. Worker classification and other payroll tax issues can be challenging.

Please contact us at (800) 477-7458 to discuss any questions regarding employee classifications that you might have.