Updated: Oct 8, 2020
Would these fees and penalties break your business:
41.5% back taxes for the last 3 years, up to a year in jail, a fine as high as $500,000 for corporations, labeled as a "tax evader", and ACA excise tax penalties based on your entire workforce.
In most cases these penalties would put an end to a business, and potentially cause significant personal and family stress.
The bottom line is IT DOES NOT PAY TO MISCLASSIFY WORKERS.
If you currently have workers classified as independent contractors, below is the litmus test to make sure you are doing it correctly.
The DOL (Department of Labor) and the IRS have two separate tests for determining proper worker status, and your state may have more severe tests (i.e. California) so check your state laws as well.
Test 1: DOL Economic Realities Test
6 worker classifications to analyze:
1. Is Their Work Integral To The Business?
Simple example: Chef and server at a restaurant vs a graphic designer contracted to re-do the menu.
The chef and server are integral to running the business. The designer is not.
2. Does Their Managerial Skill Affect Their Opportunity For Profit or Loss?
If they can contract out their work due to their managerial skill, they could be an independent contractor
3. Who Owns The Facilities And Equipment?
Rule: If the tools and facilities used to get work done are owned by employer, the worker is a W2 employee; if owned by the worker or they are paying office rent or professional dues for their license, then they are more likely a 1099.
4. Can They Contract With Other Parties?
Rule: If they can contract for their work elsewhere they are a 1099 (California has really strict rules here, so check the state laws for details); but if their contract has locked them down so they can't contract elsewhere then they would be classified as an employee.
5. Is The Relationship Open or Job Specific?
If the relationship is open ended with no specific termination of services then they are an employee; if the relationship is based on a specific scope of work or project and the relationship terminates after completion then they are 1099.
6. What is The Nature And Degree of Control?
If you have control over where, when and how they do the job, they are most likely an employee.
Remember, there are no exceptions to these rules. You can't make someone a 1099 simply because you or they want it to be so.
Test 2: IRS Right To Control Test
1. Behavioral Control
This is essentially the same as #6 above with a couple additions:
a. Does the employer have the right to control how, when and where the work is done?
b. Wow will you be evaluating work? If along the way, then they are an employee.
c. If you provide any kind of ongoing training to the worker then they are an employee.
Keep in mind that it's not necessarily a matter of whether control is exerted, but could control be exerted. If the employer could exert control in any of these cases the worker is an employee.
2. Financial Control
The basic idea here is who owns the tools, facilities and risk of a job as well as where and by who work can be done.
a. Investment: who paid for the tools or other job related materials? If it was the worker, then they are a 1099 contractor
b. Unreimbursed Expenses: Does the worker pay for rent or professional licensing that you will not be reimbursing? If so, they are a 1099 contractor.
c. Can the worker offer their services elsewhere on the market independent of your approval? If so, they are a 1099 contractor.
d. Method of payment: if you pay with a check or wire based on the project, then they are 1099; if you run them through payroll, they are an employee.
3. What Is The Nature Of The Relationship?
a. If you have a written contract in place it must specify the worker is an employee. But even so, if you treat them as an employee in any of the other tests outlined here, then the law will side with the employee.
b. Do you offer benefits? If so, they are definitely an employee. You can't offer benefits and then treat them as a 1099 contractor.
c. Is the relationship permanent and are their activities key to operating the business? If so, they are an employee.
The good news is the tests are pretty simple. There is overlap between the DOL test and the IRS test so identifying the status of the worker takes just a little analysis.
The best approach is to start with the assumption they are an employee and work backwards.
Compliance may be a pain, but it's not as painful as the penalties of not being compliant.
Here is a short list of consequences of improper classification:
Wage law violations
Unemployment insurance shortfalls
Workers comp violations
Improper exclusion from benefit plans
FMLA Act violations
Mistreatment of military personnel
WARN Act violations
Age discrimination liability
Even if you just made an honest mistake, the government will still slap you with fines:
$50 for each form W2 that was not filed.
Penalties of 1.5% of wages + 40% of FICA taxes that were not withheld and 100% of the matching FICA taxes you should have paid.
Plus interest from the date those should have been paid.
Also you'll get a failure to pay taxes penalty equal to 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability.
On the other hand, if you were deliberate, or even if the IRS suspects fraud it can impose additional fines and penalties. For instance, the employer could be subjected to penalties that include 20% of all wages paid, plus 100% of the FICA taxes, both the employee's and the employer's share.
You'll get nailed with Criminal penalties of up to $1,000 per misclassified worker and potentially one year in prison while potentially being held personally liable for any uncollected tax.
Again, compliance is no joke.
The bottom line is most workers are employees not contractors.
Get it right so your business can be protected and prosper properly (or at least in accordance with law).
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, legal or tax advice. If you have any legal or tax questions regarding this content or related issues, then you should consult with your professional legal or tax advisor.