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Business owners must be able to correctly distinguish whether the people who work for them are employees or independent contractors. This distinction is important, as employers must withhold income taxes, withhold and pay Medicare and Social Security and pay unemployment taxes for any wages paid to employees. These responsibilities do not apply to payments made to independent contractors.

There are several main factors that clarify the classification of a worker. These include the following:

• Finances: Does the payer control the business elements of the worker’s job? Consider how the worker gets paid, whether any of the worker’s expenses are reimbursed and who provides the tools or supplies needed for the job.
• Behavior: Does the company have any control (or the right to control) how the worker performs his or her job? If so, the worker should likely be an employee rather than an independent contractor.
• Relationship: Are there any written contracts or employee-type benefits in the relationship between payer and worker? A worker who is provided a pension plan, insurance and sick time is definitely an employee.

There is no set number of factors that automatically make someone an employee versus an independent contractor. Ultimately, it is up to businesses to weigh the evidence for themselves and make an honest interpretation of the worker’s classification. Employers should document all the factors used in this decision-making process in case they need to present detailed evidence to the IRS.

If the employer is still unsure about the proper classification of the worker after analyzing all the available evidence, the company can file Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) with the IRS. It may take more than six months for the IRS to return a determination of the worker’s status, so employers should be prepared for a wait.

What happens if an employer misclassifies a worker?

If an employer classifies an employee as an independent contractor without a reasonable justification for the decision, the IRS could force that employer to pay employment back-taxes for the worker. These back taxes can be calculated as high as 41.5% of the contractors’ wages, and can reach back as far as three years. If there is evidence that the misclassification was a willful violation, criminal convictions are possible, resulting in huge fines and possible jail time.

Workers who believe they have been misclassified may file a Form 8919 (Uncollected Social Security and Medicare Tax on Wages) to report their share of uncollected Social Security and Medicare taxes.

There is also a relatively new program called the Voluntary Classification Settlement Program (VCSP), which allows taxpayers to reclassify workers as employees for future tax periods for the purposes of employment taxes, while getting partial relief from federal employment taxes for any eligible taxpayers who agree to treat workers as employees. The taxpayer must meet a variety of eligibility requirements to participate in the program, and apply to participate by submitting a Form 8952, Application for Voluntary Classification Settlement Program.

Be sure to classify workers correctly

As an employer, you must be sure that you are properly classifying the individuals providing services to your business or organization. For more information, check out more resources from the IRS, and consult a legal professional to cover all your bases.