Misclassifying Employees as Independent Contractors
With everyone looking to tighten their belts in today’s economy, the question comes up whether a business should try and save money by reclassifying its employees as independent contractors. Some of the potential savings of using independent contractors may be in the areas of workers’ compensation insurance and payroll taxes. Businesses are generally required to provide and pay for workers’ compensation insurance for the benefit of their employees. Businesses are also generally required to withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to their employees. Independent contractors are not employees and thus do not trigger the incursion of these costs by those businesses for whom they provide services.
Misclassifying an employee as an independent contractor, however, may have tax consequences. In addition, misclassifying an employee as an independent contractor may result in the business having to back-pay premiums otherwise owed for workers’ compensation insurance. A business may also face liability if an employee were to get injured on the job for which there was no workers’ compensation insurance because the injured employee was misclassified as an independent contractor. It is therefore important to understand the difference between an independent contractor and an employee.
Generally speaking, the issue boils down to how much “control” your business has over the person performing the services. The more control, the more likely you have an employer/employee relationship as opposed to an independent contractor relationship.
Arizona has a law that addresses the issue with regard to workers’ compensation insurance; namely, Arizona Revised Statute § 23-902. In a nutshell, that law provides that a written agreement signed and dated by and between a business and an independent contractor that discloses that the contractor is not entitled to workers’ compensation benefits and contains the following criteria creates a rebuttable presumption of an independent contractor relationship:
(1) The business does not require the contractor to perform work exclusively for the business;
(2) The business does not provide the contractor with any business registration or licenses required to perform the agreed upon services;
(3) The business does not pay the contractor a salary or hourly rate instead of the amount fixed in their written agreement;
(4) The business will not terminate the contract prior to the expiration of the written agreement, unless the contractor breaches the agreement or violates Arizona law;
(5) The business does not provide the contractor with tools;
(6) The business does not dictate the contractor’s time of performance;
(7) The business pays the contractor in the name stated in their written agreement; and
(8) The business and contractor will not commingle their business operations rather than maintain separate operations.
Again, the presumption is rebuttable and lost if the consent of either party to a written agreement is obtained through misrepresentation, false statement, fraud, intimidation, coercion or duress. Thus, it is not enough to simply recite these criteria in a written agreement in order to try and avoid the cost of paying workers’ compensation insurance premiums. The written agreement should accurately reflect the actual working relationship between the parties.
The IRS appears to have its own set of guidelines. No surprise, these guidelines also focus on the issue of “control.” Information about these guidelines can be found at the IRS’s web site. According to the IRS:
Facts that provide evidence of the degree of control and independence fall into three categories:
Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.
The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.
For those that may desire a determination from the IRS, either the business or the person providing the services can fill out and submit a Form SS-8. The IRS will review the facts and circumstances of the case presented and render a determination. The process can take at least six months, and, as the IRS points out on its web site: “Once a determination is made (whether by the business or by the IRS), the next step is filing the appropriate forms and paying the associated taxes.”
Before deciding whether your business should reclassify its employees as independent contractors, you should consult with your attorney and tax advisor.