Six myths that lead to worker misclassification
These myths may give employers an unwarranted sense of security, and they can have costly consequences.
August 26, 2013
Employers face an important decision in classifying their workers for tax treatment. Workers can be classified as employees, who receive Form W-2, Wage and Tax Statement, or as independent contractors, who receive Form 1099-MISC, Miscellaneous Income. There are decision criteria to help businesses properly classify their workers, but businesses have incentives to classify their workers as independent contractors. When workers are classified as independent contractors instead of employees, businesses don’t have to pay employment taxes and costly employee benefits, or comply with myriad employer rules.
In the next several years, businesses will have another reason to misclassify workers. In 2015, when the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148, is fully implemented, businesses with 50 or more employees will be required to provide health insurance to employees to avoid a penalty. That penalty could be as high as $3,000 per worker. Businesses wanting to avoid the employer mandate to provide health insurance will have further motivation to classify workers as independent contractors.
The IRS has a big stake in proper worker classification. When workers are classified as independent contractors and should be employees, the government loses out on employment tax revenue. In the last quantifiable study done on worker misclassification, for tax year 1984, the U.S. Government Accountability Office estimated that 15% of employers misclassified 3.4 million workers as independent contractors, costing the federal government $1.6 billion. The current amount lost is unknown, but the IRS is completing a study that will help quantify the extent of the problem. Results of this study are due in 2015.
Six myths give a false sense of security
The determination of proper worker classification is based on whether the worker or the business has the right to control the worker.
In practice, this determination is complex and subjective, leaving businesses and their CPAs to interpret the facts and circumstances. The IRS doesn’t have a clear, bright-line test to determine classification. The IRS evaluates the facts and circumstances of each case and considers the 20 factors found in Rev. Rul. 87-41 in determining whether an individual is an employee under the common law rules.
In some circumstances, businesses may try to rely on one or more of the following common practices to classify a worker as an independent contractor. However, these practices are myths that don’t prevent IRS scrutiny and can have costly consequences.
Myth 1: We had a signed contract
A business engages a worker. The worker signs an agreement with a clause stating that the worker’s relationship to the business is that of an independent contractor. The business is confident that the agreement defines the relationship between the parties.
The reality is that proper worker classification is based on the actual working relationship between both parties. IRS auditors regularly look past contract clauses and look to evidence indicating who has the right of control. Agents are trained to consider the written contract only in “gray area” circumstances.
Myth 2: Everyone else is doing it
A business asserts that because other businesses in its industry, including its competition, treat certain types of workers as independent contractors, it can too. While this approach may have some merit if the treatment is a long-standing industry practice, employers should not rely on it without deep analysis. To prove reasonable reliance, the business should be able to provide documented evidence that it used to determine worker status before engaging the worker.
The IRS often finds that employers’ reliance on this approach does not come from documented knowledge, such as surveys, studies, and other informed evidence on industry practices. Rather, businesses often rely on after-the-fact assumptions to justify independent contractor treatment that the IRS easily dismisses in a worker status determination.
Myth 3: The worker was in a probationary period
A business wants to “try out” a worker before making a hiring decision. During the probationary period, the business treats the worker as an independent contractor. If the business is satisfied with the worker’s performance, the worker is hired as an employee. The IRS often questions this practice when it determines that the worker received a Form 1099 and a Form W-2, with no substantive change in the work performed or in the business-worker relationship.
Myth 4: They were part-time workers
A business hires part-time, temporary, or seasonal workers and classifies them as independent contractors, when they are actually employees. In classifying workers this way, many businesses want to avoid the administrative costs associated with employee status, especially when the workers are paid only small amounts or are paid significantly less than similar employees.
This myth is quickly dispelled when evidence indicates that the work performed is substantially similar to the work performed by other full-time workers or a class of workers who are treated as employees. Going forward, reliance on this myth will be even riskier, because new PPACA requirements suggest that the status of part-time workers could see significant scrutiny. Under the PPACA, part-time employees will be included in the computation of total employees to determine whether employers are required to make a shared responsibility payment (penalty) if they do not provide health insurance or do not provide insurance that is affordable and provides minimum value.
Myth 5: The contractor is an independent business
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.
The IRS inadvertently overlooks many of these situations in audits because auditors commonly look for Forms 1099 issued to individuals with Social Security numbers. The worker’s business name and EIN may disguise an employee-employer relationship. Businesses should not automatically treat workers with EINs as independent contractors and instead should look at the substance of the worker relationship to determine proper classification.
Myth 6: Out of sight, not on payroll
A business treats workers who don’t work on business premises—at home, for instance—as independent contractors. As the IRS points out in its training materials, with today’s technological capabilities, off-site work is consistent with any type of worker. Relevant factors in weighing this determination include the worker’s personal investment, unreimbursed expenses, and the opportunity for profit or loss.
At federal and state levels, the stakes are getting higher for misclassification of workers, and this issue will only get more attention as the PPACA is implemented. It’s best to help your business clients properly classify workers before the work begins—and to help them see that the myths discussed in this article are just that: myths.