It is important now more than ever to correctly classify workers as employees or independent contractors. The Internal Revenue Service (IRS) has begun finding new ways to generate revenue and crack down on the misclassification of independent contractors.

Businesses that unintentionally misclassify an employee as an independent contractor can face a number of penalties including the following:

Not withholding Federal income tax penalty = 1.5% of wages

Not withholding the employee’s share of Social Security and Medicare taxes penalty = 20 % of the employee’s share of the tax

The employer is also liable for the full amount of federal income taxes that should have been withheld and 100% of the employee’s and employer’s share of Social Security and Medicare taxes.

There is a newly enacted statute (Labor Code §226.8) for businesses that are determined to have knowingly classified workers as independent contractors. It states, any entity that “willfully misclassifies” an individual as an “independent contractor,” when that individual is determined to have actually been an “employee,” faces stiff civil penalties and unprecedented repercussions — all in addition to the existing penalty structure. Fines start at $5,000 and range as high as $15,000 per violation. Further, if the entity is found to have engaged in a “pattern or practice” of misclassification, these fines skyrocket up to a minimum of $10,000 per violation, with a cap of a whopping $25,000 per violation.

The question of whether or not your worker is an independent contractor usually hinges on how much control you have over that worker. The more control you exercise over an individual, the more likely he or she should be classified as an employee.

To help determine whether an individual is an employee under the common-law rules, the IRS has identified the 20 common-law factors in Rev. Rul. 87-41 as follows:

  1. Instructions: If the person for whom the services are performed has the right to require compliance with instructions, this indicates employee status.
  2. Training: Worker training (e.g., by requiring attendance at training sessions) indicates that the person for whom services are performed wants the services performed in a particular manner, this indicates employee status.
  3. Integration: Integration of the worker’s services into the business operations of the person for whom services are performed is an indication of employee status.
  4. Services rendered personally: If the services are required to be performed personally, this is an indication that the person for whom services are performed is interested in the methods used to accomplish the work, which indicates employee status.
  5. Hiring, supervision, and paying assistants: If the person for whom services are performed hires, supervises, or pays assistants, this generally indicates employee status. However, if the worker hires and supervises others under a contract pursuant to which the worker agrees to provide material and labor and is only responsible for the result, this indicates independent contractor status.
  6. Continuing relationship: A continuing relationship between the worker and the person for whom the services are performed indicates employee status.
  7. Set hours of work: The establishment of set hours for the worker indicates employee status.
  8. Full time required: If the worker must devote substantially full time to the business of the person for whom services are performed, this indicates employee status. An independent contractor is free to work when and for whom he or she chooses.
  9. Doing work on employer’s premises: If the work is performed on the premises of the person for whom the services are performed, this indicates employee status, especially if the work could be done elsewhere.
  10. Order or sequence test: If a worker must perform services in the order or sequence set by the person for whom services are performed, that shows the worker is not free to follow his or her own pattern of work, and indicates employee status.
  11. Oral or written reports: A requirement that the worker submit regular reports indicates employee status.
  12. Payment by the hour, week, or month: Payment by the hour, week, or month generally points to employment status; payment by the job or a commission indicates independent contractor status.
  13. Payment of business and/or traveling expenses: If the person for whom the services are performed pays expenses, this indicates employee status. An employer, to control expenses, generally retains the right to direct the worker.
  14. Furnishing tools and materials: The provision of significant tools and materials to the worker indicates employee status.
  15. Significant investment: Investment in facilities used by the worker indicates independent contractor status.
  16. Realization of profit or loss: A worker who can realize a profit or suffer a loss as a result of the services (in addition to profit or loss ordinarily realized by employees) is generally an independent contractor.
  17. Working for more than one firm at a time: If a worker performs more than de minimis services for multiple firms at the same time, that generally indicates independent contractor status.
  18. Making service available to the general public: If a worker makes his or her services available to the public on a regular and consistent basis, this indicates independent contractor status.
  19. Right to discharge: The right to discharge a worker is a factor indicating that the worker is an employee.
  20. Right to terminate: If a worker has the right to terminate the relationship with the person for whom services are performed at any time he or she wishes without incurring liability, this indicates employee status.

If, after reviewing the 20 common-law factors, it is still unclear whether a worker is an employee or an independent contractor, Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding can be filed with the IRS. The form may be filed by either the business or the worker. The IRS will review the facts and circumstances and officially determine the worker’s status.

Be aware that it can take at least six months to get a determination, but a business that continually hires the same types of workers to perform particular services may want to consider filing the Form SS-8.

If you have a reasonable basis for not treating a worker as an employee, you may be relieved from having to pay employment taxes for that worker. To get this relief, you must file all required federal information returns on a basis consistent with your treatment of the worker. You (or your predecessor) must not have treated any worker holding a substantially similar position as an employee for any periods beginning after 1977. See Publication 1976, Section 530 Employment Tax Relief Requirements for more information.

The Voluntary Classification Settlement Program (VCSP) is a new optional program that provides taxpayers with an opportunity to reclassify their workers as employees for future tax periods for employment tax purposes with partial relief from federal employment taxes for eligible taxpayers that agree to prospectively treat their workers (or a class or group of workers) as employees. To participate in this new voluntary program, the taxpayer must meet certain eligibility requirements, apply to participate in the VCSP by filing Form 8952, Application for Voluntary Classification Settlement Program, and enter into a closing agreement with the IRS.

TO 1099 OR NOT TO 1099?

Generally when the following four conditions are met you must report a payment as nonemployee compensation (box 7 on
1099-Misc):

  1. You made payments to someone who is not your employee.
  2. The payments made to the payee of at least $600 during the year.
  3. The payments you made to the payee were for services (not for product or merchandise).
  4. The payments were made to an individual, partnership, estate, or in some cases a corporation (attorneys).

The following are examples of payments to be reported as non-employee compensation:

  1. Professional service fees, such as fees to attorneys (including corporations), accountants, architects, contractors, engineers, etc.
  2. Payment for services, including payment for parts or materials used to perform the services if supplying the parts or materials was incidental to providing the service. For example, report the total insurance company payments to an auto repair shop under a repair contract showing an amount for labor and another amount for parts, if furnishing parts was incidental to repairing the auto.
  3. Fees paid by one professional to another, such as fee-splitting or referral fees and Payments by attorneys to witnesses or experts in legal adjudication.
  4. Commissions paid to nonemployee salespersons that are subject to repayment but not repaid during the calendar year.
  5. A fee paid to a nonemployee, including an independent contractor, or travel reimbursement for which the nonemployee did not account to the payer, if the fee and reimbursement total at least $600. To help you determine whether someone is an independent contractor or an employee, see Pub. 15-A.
  6. Payments to non-employee entertainers for services. Use Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, for payments to nonresident aliens.
  7. Exchanges of services between individuals in the course of their trades or businesses. For example, an attorney represents a painter for nonpayment of business debts in exchange for the painting of the attorney’s law offices. The amount reportable by each on Form 1099-MISC is the FMV of his or her own services performed. However, if the attorney represents the painter in a divorce proceeding, this is an activity that is unrelated to the painter’s trade or business. The attorney must report on Form 1099-MISC the value of his or her services. But the painter need not report on Form 1099-MISC the value of painting the law offices because the work is in exchange for legal services that are separate from the painter’s business.
  8. Taxable fringe benefits for nonemployees. For information on the valuation of fringe benefits, see Pub. 15-B, Employer’s Tax Guide to Fringe Benefits.
  9. Gross oil and gas payments for a working interest.
  10. Payments to an insurance salesperson who is not your common law or statutory employee (See Pub. 15-A for the definition of employee). However, for termination payments to former insurance sales people see page 4 of the 1099-Misc instructions.
  11. Directors’ fees as explained under Directors’ fees on page 3 of the 1099-Misc instructions.
  12. Commissions paid to licensed lottery ticket sales agents as explained under Commissions paid to lottery ticket sales agents
    on page 3 of the 1099-Misc instructions.
  13. Payments to section 530 (of the Revenue Act of 1978) workers. See the TIP on page 3 of the 1099-Misc instructions.
  14. Fish purchases for cash. See Fish purchases on page 2 of the 1099-Misc instructions.