Tax challenges can be VERY expensive
As a small business owner, you may face the issue of whether to classify workers as employees or as independent contractors.
Classifying your workers as independent contractors generally saves you money. That’s because you avoid paying employment taxes and benefits on their behalf.
If the IRS determines that you misclassified your employees as contractors, you could end up paying all of the employment taxes and benefits that would have been paid over the years. Depending on the size of your work force, the cost to your business could be substantial.
In determining whether the person providing a service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered. There are three primary categories of control and independence that the IRS considers when determining if a worker is a contractor or an employee:
- Behavioral. Does the company control or have the right to control what the worker does and how the worker does his or her job? If yes, the worker is an employee.
- Financial. Are the business aspects of the worker’s job controlled by the payer? This includes things like how the worker is paid, whether expenses are reimbursed and whether the employer provides tools and supplies. If yes, the worker is an employee.
- Type of relationship. Are there written contracts or employee-type benefits? If contracts are involved, the worker may be a contractor. If benefits such as a pension plan, insurance and vacation pay are made available, the worker most likely is an employee.
Deciding whether a worker is a contractor or employee can get complicated. And remember that there are significant financial consequences for incorrectly classifying a worker.
QUICK BACKGROUND
California Assembly Bill 5 (AB5), went into effect on January 1, 2020 and requires companies that hire independent contractors to reclassify them as employees, with a few exceptions. The biggest question regarding AB5 was how to differentiate between an employee and a contractor. The California Supreme Court created a three-way test to help, commonly called the ABC Test:
- The worker can perform services free of the company’s control and/or direction.
- The worker performs tasks that are outside of the company’s regular activities.
- The worker is also engaged in an independently established trade or business.
KEY TAKEAWAYS
- California Assembly Bill 5 (AB5) extends employee classification status to gig workers.
- Companies must use a three-pronged test to prove workers are independent contractors, not employees.
- AB5 is designed to regulate companies that hire gig workers in large numbers, such as Uber, Lyft, and DoorDash.
- On Aug. 10, 2020, a California judge ruled against Uber and Lyft for failing to comply with the law.
- And on Sept. 4, 2020, the Calif. legislature passed—and Governor Gavin Newsom signed—Assembly Bill 2257, which exempts a long list of job categories from AB5 strictures. It went into effect immediately.
Among those exempted from the strictures are still and video photographers and editors, freelance writers, content contributors, editors, translators, fine artists, and musicians. One key change was the removal of caps for categories of freelancers that had limited the number of contributions they could make to an outlet, such as a website, without having to be reclassified as employees. Not exempted: Workers for gig-economy companies such as Lyft and Uber.
As usual, navigating the constantly changing legal landscape for independent contractor status can be very complicated. If your business uses, or is thinking of using, independent contractors to assist with any business functions, make sure you contact a legal professional to make sure you are staying compliant with the latest legal developments.
Is a worker an independent contractor or an employee? This seemingly simple question is often the contentious subject of IRS audits. As an employer, getting this wrong could cost you plenty in the way of Social Security, Medicare, and other employment-related taxes. Here is what you need to know.
The basics
As the worker. If you are a contractor and not considered an employee, you must:
- Pay self-employment taxes (Social Security and Medicare-related taxes)
- Make estimated federal and state tax payments
- Handle your own benefits, insurance and bookkeeping
As the employer. You must ensure your employee versus independent contractor determination is correct. Getting this wrong in the eyes of the IRS can lead to:
- Payment and penalties related to Social Security and Medicare taxes
- Payment of possible overtime including penalties for a contractor reclassified as an employee
- Legal obligation to pay for benefits
Things to consider
When the IRS re-characterizes an independent contractor as an employee, they look at the business relationship between the employer and the worker. The IRS focuses on the degree of control exercised by the employer over the work done and they assess the worker’s independence. Here are some guidelines:
- The more the employer has the right to control the work (when, how and where the work is done), the more likely the worker is an employee
- The more the financial relationship is controlled by the employer, the more likely the relationship will be seen as an employee and not an independent contractor To clarify this, an independent contractor should have a contract, have multiple customers, invoice the company for work done, and handle financial matters in a professional manner
- The more businesslike the arrangement, the more likely you have an independent contractor relationship
While there are no hard-set rules, the more reasonable your basis for classification and the more consistently it is applied, the more likely an independent contractor classification will not be challenged.