IRS and YOU

Urgent: Misclassifying Employee Status is hazardous to your Business Health

In our daily operations of payroll processing we often run a cross individuals compensated by a business whose employee/independent contractor status is questionable. The consequences of treating an employee as an independent contractor are severe. Our experience strongly indicated that the IRS’ preference for classifying these borderline individuals are as “employees.” The court cases available to review seems to support the IRS’ position. IRC Sect.3121(d) says that a worker is classified as an employee if ONE of the following conditions is met:

1. A common-law employee
2. A corporate officer
3. A statutory employee
4. An employee covered by an agreement under Sect. 218 of the Social Security Act

The condition that trips up most businesses is defining what a “common-law employee” is. The general tax regulations determine that an employer/employee relationship exists when a business has the right to direct and control a worker to perform service for the business.

Years ago the IRS developed a list of 20 factors relevant to determining a worker’s employment status. In large part these have been replaced by three, more general, factors:

1. Behavior Control: Whether or not the employer has the right to direct or control how a worker does his work determines if behavior control exists, irrespective of the fact that the employer may not exercise that right.
2. Financial Control: Is there a risk of profit or loss to the worker? Did the worker make a significant investment in the business? Are there unreimbursed expenses of the worker? Does the worker provide services to others in the relevant market? All of these have bearing on classifying a worker as an independent contractor or an employee.
3. Relationship of the Parties: Some aspects of a relationship help determine a worker’s classification. Written contracts certainly help clarify the intent of the relationship as well as the understanding of the parties. It may also help protect an employer from the actions of a disgruntled worker or one that later finds himself in tax trouble and is attempting to lay the responsibility on the employer. Furthermore, the ability of the employer to discharge a worker without penalty is highly indicative of an employer/employee relationship.

Where workers are determined by the IRS as being misclassified the determination brings with it the status of failure to withhold employee taxes. The back taxes and penalties can devastate a business. Of course, there is always the possibility of fighting the determination in court, but it is also a highly expensive option.

The IRS has stepped up its enforcement in this area. Businesses that have five or more 1099-status workers and/or $25,000 in 1099 payouts are more likely to be audited, although any IRS review procedure is subject to considering worker status.

If you have employees and/or contractors, it is imperative you engage a professional payroll company to advise you.

Wishing you many happy returns,

Dr. Wayne T. Essex