If you’ve hired workers for your business, you had to decide whether they should be employees or contractors. If all you hire are employees, then you have nothing to worry about. But if you hire contractors, there may be some financial risk you’re taking you may not know about.
Anyone that runs a business as a sole proprietor, who provides services you pay for, is considered a contractor. One difference between an employee and a contractor is that an employee receives a W-2 form, and a contractor to whom you’ve paid more than $600 per year by check receives a 1099. There are many other paperwork differences, but that’s the major one.
One of the biggest mistakes business owners make is thinking they can classify a worker as a contractor if they simply want to. Unfortunately, it’s the IRS that decides on the classification, not the worker or the business owner.
What’s the Risk?
There is no risk from an IRS standpoint to classify a worker as an employee instead of a contractor. But there is significant financial risk if you classify a worker as a contractor when they should be classified as an employee. You may be liable for employment taxes going back many years if the IRS re-classifies a worker from contractor to employee.
To calculate your risk, take roughly 20 percent of the payments you made to contractors. This amount, plus late fees and penalties, is what you could owe the IRS if they discover you’re misclassifying workers.
The IRS’s Employee vs. Contractor Rules
The IRS uses three factors to determine whether a worker should be a contractor or employee: behavioral control, financial control, and type of relationship.
For example, if you have control over how a worker completes their tasks, you should classify them as an employee. If you can control only the results you want, you may be able to classify the worker as a contractor.
If you’re responsible for providing your worker supplies, and you need to reimburse their expenses, it’s likely they’re an employee. But if they have to incur those costs themselves, they’re more likely to be a contractor.
Finally, if you’re expecting this worker to stay long-term, and their work is essential to your business, they should be classified as an employee. If neither are true, they’re probably a contractor.
There are many other rules about this classification, so be sure to check with your tax accountant for more information. Also, for those of you that love tax research, here’s a link that gives the full details of the IRS rules: http://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee
Having a successful business is all about taking calculated risks; however, you may not have known the risk you’ve been taking with contractors that you’ve employed. For the IRS, misclassifying workers is a “red flag” area, meaning they pay extra attention to it. If you feel like you might be taking a risk you don’t want, please reach out and let us know.