The days when a small business could ignore the risks of having misclassified workers are over.  Unfortunately, some employers improperly classify their employees as independent contractors to avoid the pain associated with having employees, namely:

Additionally, employers don’t have to cover independent contractors under workers’ compensation insurance, and are not liable for payments under unemployment insurance, disability insurance, or social security.

It’s true, the expenses associated with employees are high. However, the cost of misclassifying workers is even higher.  If your contractors are determined to really be employees you will not only be required to pay the taxes and fees you should’ve, you may also be required to pay the employee’s taxes as well.  Not to mention the stiff penalties and interest that can be imposed by both federal and state agencies for violating the various laws.

This is no small matter and is on the radar of every government agency out there, all of whom are anxious to find additional revenue sources these days.  The IRS estimates that one in seven U.S. employers is guilty of misclassifying some of its employees, resulting in a loss of more than $4.1 billion a year in tax revenues.  These days the question is no longer “if” you’ll get audited for employee misclassification it’s “when”.

For businesses facing an audit, the odds favor the IRS. A recent report found that 92 percent of the companies audited for “misclassification” were hit with significant penalties and assessed for back taxes. Between 1988 and 1995, the IRS audited more than 13,000 businesses, reclassified 500,000 of their independent contractors as employees, and levied $830 million in back taxes and penalties.

Making matters worse, sometimes the various agencies disagree.  For instance, here in California there are several state agencies involved with the determination of independent contractor status:  (1) the Employment Development Department (EDD), which is concerned with employment-related taxes, (2) the Division of Labor Standards Enforcement (DLSE), which is concerned with whether the wage, hour and workers’ compensation insurance laws apply; (3) the Franchise Tax Board (FTB), which is concerned with state income taxes; (4) the Division of Workers’ Compensation (DWC), which is concerend with worker’s compensation; and (5) sometimes even the Contractors State Licensing Board (CSLB), that also have regulations or requirements concerning independent contractors  and it’s not uncommon for one to rule that a worker is an employee while another rules that the same worker is an independent contractor.

Because the potential liabilities and penalties are so significant if an individual is treated as an independent contractor and later found to be an employee, each individual working relationship needs to be thoroughly analyzed to make sure every single worker is properly classified.  Now is not the time to group classes of employees together.  Just because one of your workers qualifies as an independent contractor, don’t assume that all the others doing similar work will.

It all boils down to control – does your business have control or the right to control the worker both as to the work done and the manner and means in which it is performed? The IRS breaks control down into three categories:  behavioral control, financial control, and relationship of the parties. It is very important to consider all the facts for every single one of your worker relationships – no single fact provides the answer.

Behavioral Control

These facts show whether there is a right to direct or control how the worker does the work.

Financial Control

These facts show whether there is a right to direct or control the business part of the work. Here are a few questions to ask yourself:

Type of Relationship

These facts show how the business and the worker perceive their relationship.

You’d think that a written contract detailing that you and your worker agree that you are not creating an employer-employee relationship is all that’s needed, but unfortunately this isn’t the case.  It may certainly help, especially is you subsequently issue a 1099 form instead of a W-2 form, but even this doesn’t guarantee protection.

QuickBooks handles W-2′s differently based on which payroll subscription you’ve chosen.  There are three options available:

If you decide to classify some or all of your workers as independent contractors, there isn’t as much paperwork but there are some reporting requirements:

If setup properly, QuickBooks can help you track all the information needed for 1099′s.  Here’s how:

In the end, how to classify your workers is a business decision that only you can make.  You may save money upfront by classifying them as independent contractors, but you could end up paying much more in the long run if they are reclassified.  Protect yourself as much as possible with a paper trail – contracts, agreements, written answers to the questions listed above.  You might even  consider requiring your independent contractors to prove you with documentation that they are actually operating a small business themselves, such as a business license, Doing Business As (DBA) or Tax ID number from the IRS.

If you need additional assistance, please call our QuickBooks technical support line at 888-351-5285. We are here to help you get the most out of QuickBooks!

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