Worker classification is a complicated yet crucial responsibility of employers. Correctly determining if a worker should be treated as an employee or an independent contractor (IC) should be a top priority when hiring someone to perform work for your company.
The IRS estimates that 30% of businesses are misclassifying workers, resulting in over $7 billion in lost federal tax revenues. Everyone is affected when businesses misclassify workers: the IRS has budgeted $14 million in 2013 to detect and deter misclassification, and has also hired additional full time employment auditors for this purpose. In addition, they have budgeted grant money to assist states in pursuing worker classification errors, and have offered rewards for states that set up their own programs to detect and deter misclassification.
There is a longstanding misconception among employers that anyone making less than $600 a year can be treated as an IC. In fact, there is no limit on amount of dollars or number of hours worked that can determine how to treat a worker with respect to classification.
When an employee is classified as an IC, the employer is not required to offer benefits, collect and pay in taxes or contribute company taxes.
Classification is based on various criteria, all focusing on the “right of control.” An employer-employee relationship exists when the person for whom the services are performed has the “right to control and direct” the individual performing the service with regard to the results of the work and the measures used to accomplish those goals. This control can be divided into three areas: behavior, financial and relationship.
- Behavior focuses on the ability to perform the work independently. Does the company or the worker set the hours for the work to be done, determine where the work will be performed, and assume control over how the work will be completed?
- Financial focuses on who has the financial investment in the work being done. Who owns/controls the equipment and tools used to complete the job and who realizes the profit or loss with regard to completing the job?
- Relationship focuses on the form of payment to the worker. Is there an hourly rate/salary or is there a contractual payment when the job is complete? In addition, a contractor has the ability to accept or reject jobs without detriment, and cannot be fired unless specifically defined in their contract.
There are three agencies that regulate worker classification. Each has their own definition and criteria for making a determination. Many times the factors each of these agencies look at overlap, but in some situations, one agency may make one determination while another opposes. This makes classification for employers even more complex and frustrating.
- The Wisconsin Unemployment Agency identifies nine criteria of ICs. A worker must meet any six of them to be determined an IC.
- The Wisconsin Workers Compensation Agency also has a list of nine criteria and a worker must meet all of them to be classified an IC.
- The federal classification of a worker is not as simple: the IRS reviews the substance of each individual case to make a determination. There are no set criteria or number of factors a worker must meet. If you are unsure about how a worker should be classified, submit Form SS-8 to the IRS. It can take up to six months to receive their determination.
Because of the inconsistencies between agencies and the complexity involved in identifying an IC, we recommend that you consult with your tax professional or attorney before making any determinations that you have any questions on.
Businesses that have correctly classified workers as ICs are subject to annual filing requirements. You should file Form 1099-M for all contractors (except corporations) earning more than $600 annually.
Electronic filing requirements and limits are the same for ICs as for employees. You do not need to withhold employment taxes from ICs unless they request it, but you do need to deduct any garnishments you receive on ICs.
If you do not receive a completed W-9 for each contractor stating their name and federal ID number, you are required to withhold and submit 28% federal income tax from all payments made to the contractor. This amount could increase to 31% in 2013.
Each state has different criteria and reporting requirements. If you are a multi-state business, be sure to check the requirements of all states you do business in.
If you think your business has been misclassifying employees as independent contractors, you can voluntarily come forward and possibly reduce your liability. The Voluntary Classification Settlement Program allows you to reclassify workers as employees with partial relief from past federal employment taxes, penalties and risk of audit. You must have consistently treated workers as ICs and filed 1099s for them and you cannot currently be under an employment audit. Use Form 8952 to apply. It can take up to sixty days to receive an answer. You should not change the way you treat these workers until you receive a response to your application.
You can view the specific conditions for each agency through the following websites:
For more information, contact Libby Welhouse or any member of our payroll team.
Elizabeth Welhouse, CPP, is a payroll specialist with Schenck. Libby specializes in determining the best payroll processing solutions to fit client needs. She implements new payroll client startups and does payroll software training, along with building and maintaining client exports.