One of the worst errors employers can make is misclassification of workers. Simply put, if workers look like they can possibly be construed to be employees, the IRS will try to take that position. If you disagree, too bad for you, tough, lump it. They will assess you anyway. You can contest or appeal their assessment, but that procedure is neither easy nor cheap. If a state agency has occasion to reclassify your employees, they will tattle to the IRS, which will come knocking on your door in short order. The taxing agencies feel that every working person in the United States should get a Form W-2, instead of a Form 1099. And they have been on a determined program for more than a decade to try to accomplish that.
What does the term “Contract Labor” mean? It is roughly equivalent to “independent contractor.” I dislike the term “contract labor,” because of the labor part of it. When you hire an employee, in effect, you are buying his or her labor. Labor is what employees do, and the last thing you want to do is inadvertently imply the person is an employee. Additionally, there is rarely a real contract. Or if there is a contract, it’s usually inadequate. I prefer the term “independent contractor” to describe anybody who is doing work for a company, but not as an employee.
How do you know if a person can be legitimately classified as an independent contractor? The key issue is control over the worker. If you exercise significant control, the worker looks more like an employee than an independent contractor. You may have heard of the “20 Questions Test,” but I recommend that you only take it as a set of guidelines. This is a list of questions used by the IRS (on Form SS-8) to analyze how many characteristics of an employee versus how many characteristics of an independent contractor your workers exhibit. (It now has many more than the original 20 questions from when the form first came out, but they still call it that.) The test is based on common law precedents. Some business owners mistakenly think that if you pass more than half of the questions, you can get by. Don’t believe it. IRS agents can reclassify using just a few of the questions. (Incidentally, if you ever get a Form SS-8 in the mail from the IRS, with instructions to fill it out for one or more of your workers, it’s not a good sign.)
What if you look at the IRS list, but you’re still not sure? There are only three safe havens I know of. First, it’s good if the worker performs the same types of services, on a regular basis, for customers other than you. It is even better if that worker has a business listing in the Yellow Pages, a website, or otherwise advertises such services. Second, you will be safer if the worker’s business is incorporated (a single-member LLC is not adequate). Third, if the worker is a licensed insurance agent, or a licensed real estate agent, there are special provisions.
Why is this classification thing so important? The costs are so high that any problem can put you out of business. If you are hit with a reclassification, you will be subject to at least 15% of the total payments you’ve made to the reclassified workers for the last three years. On top of that is the possibility of penalties and interest that amount to another 15% or more. Payment to workers is usually the biggest expense of most businesses. So, if you have to go back and pay 30% or more of what you paid to contract labor workers in previous years, it can easily be enough to sink your business. Just doing a rough calculation of the numbers can be a scary experience.
So, if you get a large assessment, might you have to file bankruptcy for your business? It’s quite a bit worse than that. Payroll taxes enjoy a special category in the law, allowing the IRS special standing, such that payroll taxes are not dischargeable in bankruptcy. Worse than that, anybody in the business who had any responsibility for payroll can be charged personally, jointly and severally. That means that officers, directors, and owners can be held personally responsible to pay up for the payroll taxes and penalties due. Not only that, but anybody who was on the signature card for the business bank account can be personally liable.
If a disgruntled worker complains, or if the IRS finds out about you for any other reason, you will need a good lawyer. A good attorney can help you contest or appeal any reclassification attempt, and you will have a better hope of success than if you try to handle the problem by yourself. But, of course, a good lawyer is expensive.
I strongly recommend that you take protective measures now and be extremely careful with worker classification. It’s worth the cost of getting a professional opinion if you are at all unsure. It will be considerably cheaper to switch questionable workers to employee status and to start withholding payroll taxes on them now, than it will be to go through the trauma of a reclassification case later. I am not recommending that you be over cautious, but I am telling you to go into this with your eyes wide open and to get professional help if you have any notion that you might have a problem. I strongly recommend that you have an Attorney draft Employment Agreements for all your employees and Independent Contractor Agreements for all your Form 1099 people.