Tax Prep & Planning

6 Myths That Can Lead You to Incorrectly Classify Workers

You face an important decision in classifying your workers for tax treatment. Employees receive Form W-2, Wage and Tax Statement, and independent contractors receive Form 1099-MISC, Miscellaneous Income.

There are decision criteria to help businesses properly classify their workers, but businesses have incentives to classify workers as independent contractors. Why? Because, with independent contractors, businesses don’t have to pay employment taxes and costly employee benefits, or comply with myriad employer rules.

The IRS also has a big stake in worker classification. When workers are classified as independent contractors and should be employees, the government loses out on employment tax revenue. Classifying workers the right way boils down to whether the worker or the business has the right to control the worker. But, in reality, making this determination is tough. It’s complex and subjective, leaving businesses and their advisors to interpret the facts and circumstances of each case.

And the IRS doesn’t have a clear, bright-line test to determine worker classification. Instead, the IRS evaluates the facts and circumstances of each case using 20 factors.

In some cases, businesses may try to rely on one or more of the following common practices to classify a worker as an independent contractor. But, these practices are myths that don’t prevent IRS scrutiny and can have costly consequences.

Myth 1: “We had a signed contract.”

Even if you have a worker sign an agreement with a clause stating that the worker is an independent contractor, in reality, the right classification is based on the actual working relationship between the person and the business. IRS auditors regularly look past contract clauses and look for evidence showing who had the right of control. IRS agents are trained to consider the written contract only in “gray area” circumstances.

Myth 2: “Everyone else is doing it.”

Some businesses point to other businesses in the industry (including the competition) to show that it’s OK to classify workers as independent contractors. While this approach may have some merit if it’s a long-standing industry practice, employers shouldn’t rely on it without deep analysis.

To prove that it’s OK for your business to classify workers as independent contractors, you should be able to provide documented evidence that you used to determine the worker’s status before engaging the worker. But the IRS often finds that employers who rely on this approach don’t use documented knowledge, such as surveys, studies, and other informed evidence on industry practices. Rather, businesses often rely on after-the-fact assumptions to justify their classification of workers. The IRS easily dismisses this approach in a worker-status determination.

Myth 3: “The worker was in a probationary period.”

You may want to “try out” a worker before making a hiring decision. During the probationary period, some businesses treat workers as independent contractors before hiring them as employees, thinking that is OK since the worker hasn’t been hired yet.

But when the worker (and the IRS) receives a Form 1099 and a Form W-2 from the business, with no substantive change in the work performed or in the business-worker relationship, the IRS may see a red flag and question the classification.

Myth 4: “They were part-time workers.”

Businesses sometimes hire part-time, temporary, or seasonal workers and classify them as independent contractors instead of employees. They do this to avoid administrative costs associated with employees, especially when the workers earn only small amounts or significantly less than similar employees.

This myth is quickly dispelled when evidence shows that the part-time, temporary, or seasonal work is substantially similar to the work performed by other full-time workers or a class of workers who are treated as employees.

Myth 5: “The contractor is an independent business.”

Sometimes, when a worker has a business name and an employer identification number (EIN), the business engaging that worker automatically treats the worker as an independent contractor. But businesses shouldn’t automatically treat workers with EINs as independent contractors. Instead, they should look at the substance of the worker relationship to determine the right classification.

Myth 6: “Out of sight, not on payroll.”

Businesses may think it’s OK to treat workers who don’t work on business premises—at home, for instance—as independent contractors. But, as the IRS points out in its training materials, with today’s technological capabilities, any type of worker may work off site. To weigh this decision, the IRS would look at factors such as the worker’s personal investment, unreimbursed expenses, and the opportunity for profit or loss.

The Stakes are Getting Higher

At federal and state levels, misclassification of workers is increasingly in the spotlight. Starting out the worker relationship the right way will save you time and money in the long run — so you can focus on your passion and not on an IRS audit.

If you want to know more about the decision criteria that you should be using to determine worker status, make an appointment to see your local Block Advisors tax advisor, who can help walk you through this important step in your business.

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