Employees vs. Independent Contractors

Today's post isn't specific to Government contracting but its a subject that we believe most contractors need to be reminded of from time to time (we are a CPA firm and sometimes we just cannot help ourselves). During adverse economic conditions, it is sometimes tempting for contractors to reclassify employees as independent contractors thereby saving employment related taxes, benefits, and other expenses. The Government has always been aware of the temptations and trends and considers it one of their "high risk" areas for audit and investigation. When employees are misclassified as independent contractors, it often results in failure of the workers and employers to correctly pay income taxes, Social Security, Medicare and unemployment insurance taxes. That means substantial lost revenue to the federal and state governments.


Now that the Governments are facing increased financial pressures themselves, Federal and State agencies are starting to scrutinize "independent contractor" status with new fervor. Take President Obama's fiscal year 2011 budget for example. It includes $25 million to the Department of Labor for a joint effort with the IRS to hire investigators to find workers that can be recategorized as employees. The Administration estimates that the $25 million per year investment will bring in $10 billion over the next 10 years - not a bad ROI (return on investment) if you trust those numbers.

Here are some other examples of increased scrutiny:

• Random Audits - Beginning in February 2010, the IRS launched a three-year program to randomly audit 6,000 employers. These examinations will delve into compliance with employment tax issues, including the misclassification of independent contractors, fringe benefits, reimbursed expenses and the compensation of owner-employees.
• Information Sharing - The IRS signed information-sharing agreements in 2008 with labor and workforce agencies in 29 states, to assist them in uncovering employment tax avoidance schemes" and ensure proper worker classification."

If you utilize independent contractors, there are several things that you can do to ensure those workers are properly classified.

• Have written, signed contracts with workers classified as independent contractors, spelling out the terms and conditions of the relationship.
• Once contracts are in place, give outside workers leeway over how they perform their duties. Resist the urge to supervise them the way you oversee employees.
• Send each independent contractor a Form 1099.
• Consistently treat workers performing similar tasks as either independent contractors or employees. Don't supply outside workers with services you give employees. Some companies run into trouble after they provide office space, computers, cars and other perks.
• Maintain good records - independent contractor's taxpayer ID number, business cards, a letterhead, and invoices.
• Do a self-audit of each worker's or each class of workers' status before a federal or state agency conducts one. If you are in doubt, you can always file Form SS-8 with the IRS giving them information about a relationship and asking for their determination (many companies don't like to do this for fear of attracting unwanted attention from the IRS)

Here are some of the factors the IRS considers in determining if a worker is an employee:

• Behavioral Control - An employee generally is told when, where, and how to work, as well as what order or sequence to follow.
• Tools - An employer usually gives tools, equipment and workspace to employees. In contrast, independent contractors often provide and invest their own money in equipment, tools and facilities.
• Assistants - Employees don't hire and pay others to help them do their jobs (although they may be told to hire assistants for the company). In contrast, contractors often hire, supervise, and pay their own assistants.
• Training - Employees are more likely to receive training from an organization than independent contractors.
• Other Customers - Independent contractors generally make services available to the public and are able to work for two or more businesses.
• Financial Control and Risk - An employer has the right to control the financial aspects of a job, such as the business expenses the employee incurs and how staff members are paid. On the other hand, a worker's opportunity to personally earn a profit and assume risk of loss may indicate a non-employee status.