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Independent Contractors vs. Employees

Chris Roush, Maribeth Wright
Jul 14, 2008

Most companies employ part-time or temporary workers at some point, and these types of workers are often assumed to be independent contractors. Companies classify them as such to help save costs.

By doing this, employers do not have to match welfare taxes, including Social Security, Medicare and Federal Unemployment Taxes, which are almost eight percent of an employee's pay. Nor do they have to pay fringe benefits, ERISA, workers compensation, or withhold state and federal taxes. It also eliminates the need for ensuring minimum wage and overtime pay.

However, the IRS believes up to 80 percent of companies misclassify workers as independent contractors when they should be employees. So, what is the difference between employees and independent contractors?

Both the IRS and the Department of Labor have guidelines for worker classification. The IRS deals with payroll taxes and the Department of Labor protects workers' rights – ensuring they receive overtime pay, retirement benefits, etc.

In fact, a 1998 class action lawsuit against Microsoft Corporation awarded workers who had been classified as independent workers rights to retirement benefits because they should have been classified as employees.

Mistakes most often happen for employers that hire a high number of part-time or temporary workers, such as contractors, professional service providers or non-profits.

Guidelines for Classification

To determine a worker's status, answer this question: Is the person in business for himself or herself? Consider the following factors:

  • The worker's opportunity for profit or loss depending on his or her managerial skill
  • The degree of the worker's right to control how work is performed
  • The worker's investment in equipment or materials
  • The worker's ability to hire helpers to perform a task
  • The level of special skills required to render the service
  • The degree of permanence of the working relationship
  • The extent to which the service rendered is an integral part of the employer's business

On the other hand, independent contractors will:

  • Have other customers
  • Perform only high-level, skilled tasks
  • Advertise their services
  • Have an office outside the employer's place of business

Penalties for Misclassification

However, not all cases are punished to the full extent allowed under the law. Many are settled at the audit or during the appeals level, without involving the court, and are settled for back taxes, interest and penalties. In some cases, the employer may even be able to negotiate with the IRS, if the employer has a reasonable basis for the worker's treatment as an independent contractor and if the employer is consistent in its treatment of worker classification.

The best method of preventing misclassification is to be aware of the guidelines. However, there are many unique situations that need to be reviewed individually. The professionals at Rea & Associates can help. We also recommend reading Publication 15-A, Employer's Supplemental Tax Guide, available at www.irs.gov.

This article was originally published in The Rea Report, Winter 2006.

Note: This content is accurate as of the published date above and is subject to change. Please seek professional advice before acting on any matter contained in this article.

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