Understanding Worker Classification

By: Danielle Cottle, CPA, CGMA- Manager

For decades, worker classification has been a controversial topic between the IRS and taxpayers. According to the IRS, millions of workers are misclassified as independent contractors each year. The distinction is important because it determines if an employer must withhold income taxes and pay employer payroll taxes such as social security, medicare, and unemployment. As the tax laws continue to change, we expect for the problem to continue to grow as businesses look for ways to reduce their tax bills. With an understanding of the worker classification rules, your business can develop policies and procedures to ensure that workers are properly treated as employees or independent contractors.

To determine how to classify a worker, the IRS provides three tests:

  1. Behavioral Control: A worker is considered to be an employee when the business has the right to direct and control the work performed by the worker. Examples are:
    • Instructions are given such as when/where to work and what tools to use.
    • Evaluation systems are in place to measure the processes of how the work is to be done.
    • Training is provided about procedures and methods
  2. Financial Control: A worker is considered to be an employee when the business has the right to direct or control the financial aspects of the jobs. Examples are:
    • Significant financial investments are made in the equipment the worker uses
    • If the workers services are available to the market. Independent contractors are generally free to seek out business opportunities.
    • Method of payment. An employee is guaranteed a regular hourly or salary wage for a period of time. Independent contractors are often paid for the job by a flat fee.
  3. Relationship: The relationship can be determined based upon how other workers and business perceive the interaction or relationship to be.
    • Written contracts should be prepared to describe the relationship.
    • Benefits provided by the employer for insurance, pension plan, vacation pay etc. typically indicate an employee relationship.
    • Permanency of the relationship. If the relationship is expected to continue indefinitely, rather than job or project specific timelines, then it is generally considered to be an employee relationship.

It is important to be aware that the consequences of misclassifying an employee can be severe. The IRS can select your business at any time for a random audit. If the findings of the audit conclude that independent contractors should have been paid as employees, you could be responsible for additional employer payroll taxes, penalties and additional IRS or DOL audits. Don’t get caught with unexpected payroll tax liabilities or penalties. If you feel your company may have exposure or if you want our assistance determining how to classify a worker, please reach out to us!