#JimmyTalk: Classify employees correctly or it's a long way to fall

An independent contractor is the business world’s equivalent of a high-wire act with no net. There’s danger, but there also exists the rush of working in the spotlight alone — and the prospect of making more money.

Salaried employees of companies do necessary and important jobs, but they work with potentially less risk — and less reward — than the person on the high wire.

That comparison generally represents the difference between an IRS Form 1099 independent contractor and Form W-2 employee. Essentially, it’s a taxing issue.

A 1099 independent contractor is paid by a company either for a limited-time project or on a continuing basis — as a consultant, for example. Independent contractors pay for their computers, cellphones, office supplies and other business-related expenses.

A company using an independent contractor doesn’t pay the contractor’s benefits, such as health insurance, nor does the company withhold federal, state or local taxes from the contractor’s paycheck. The independent contractor is responsible for paying all taxes. An independent contractor reports income and deductions on IRS Schedule C. That assumes they have made enough money to pay taxes. Independent contractors aren’t guaranteed an income; they must be hired to be paid.

It may start to appear that independent contracting is more positive than negative; however, the reason many people become independent contractors is that they can set their own rates and hours, and if a client believes the value is worth the higher price, the higher goes the price.

A W-2 employee works directly for a company, which pays them, withholds the taxes, providing a W-2 with wages data to report their taxes. The company typically pays for equipment necessary for the employee to do their job. These expenses and responsibilities mean greater security and fewer costs for the employee, but may not translate into higher pay.

Independent contracting is born out of opportunity or necessity. Someone may see opportunity, so they take the plunge. Necessity’s door is opened if someone loses their job and hangs out their independent contractor shingle because it’s the most attractive option. That doesn’t mean they won’t be successful, but nothing is guaranteed.

The IRS takes great interest in the correct classification of contractors and employees. If an employee is misclassified as an independent contractor, the company avoids administrative requirements and costs. It also means that the government isn’t receiving the taxes it’s due: Government objects to such treatment.

The IRS has a series of standards applied to classification, among them a set of common law rules

  • Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
  • Financial: Are the business aspects of the worker’s job controlled by the payer? (These include things like the how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
  • Type of relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

If an employer misclassifies a W-2 employee as an independent contractor, the employer faces penalties of up to 41.5% of the independent contractor’s wage payments potentially going back three years. These back taxes can also be assessed on the company’s owners and officers.

Also, the employer may be liable for the benefits that went unpaid to the misclassified employee. These costs may include health coverage, retirement plan contributions, health insurance and overtime, as well as additional IRS fines.

Incorrect classification puts an employer on a dangerously thin high wire, with much less chance of a successful outcome. Employers should check with professionals who know what employee goes where; otherwise, it’s a long way to fall.


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This article first appeared in KnoxNews. 

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