Is your janitor, maintenance worker, or sub-contractor really an independent contractor? Business owners are tempted to classify some workers as “independent contractors” to avoid payroll taxes, benefits and workers compensation expense. Then they discover, too late, that they are technically “employees” and face huge costs and fines! A crackdown on misclassification of workers began in September 2011 with a Memorandum of Understanding (MOU) between the IRS and US Department of Labor.  Under this agreement, the agencies work together and share information to improve compliance with federal labor laws.

It is critical that business owners correctly determine whether the individuals providing services are employees or independent contractors. The correct answer may not be obvious. Before you can determine how to treat payments you make for services, you must first know the business relationship that exists between you and the person performing the services. In determining whether they are an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.

The Internal Revenue Service has created a website to assist you in correctly determining a workers status for tax purposes called Independent Contractor (Self-Employed) or Employee?  There are resources and forms on this website that will help you determine if a person performing services is an independent contractor, a common-law employee, a statutory employee or statutory non-employee. Facts that provide evidence of the degree of control and independence fall into three categories: behavior, financial and type of relationship. Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor.

Workers Compensation rules vary from state to state and may differ from the IRS regulations in determining whether a worker is an independent contractor or employee. Even if a worker is found exempt by the IRS you may need to cover the worker for Workers Compensation. The Idaho Industrial Commission provides a brochure called Independent Contractor or Employee?  with definitions, right to control test, and quick facts that will assist you.

A Quick Test – use this 20 question checklist to help you determine a worker’s status:  Twenty Factor Checklist to Determine Independent Contractor vs. Employee Status. 

Federal and State Regulatory Initiatives – following the “great” recession that squeezed revenues for federal and state budgets, the Obama administration and states are highly motivated to stop misclassifications and collect taxes and fines.  In February 2010, the IRS announced that it was commencing an Employment Tax National Research Project to conduct line-by-line audits of 6,000 businesses focusing on, among other things, employee misclassification. The federal budget for Fiscal Year 2013 also finances inter-agency cooperation with $14 million budgeted in the coming year for grants to states to assist them in identifying misclassification and recovering unpaid taxes. The U.S. Department of Labor has also initiated a “Misclassification Initiative” in which it has entered into memorandums of understanding with 13 states from coast to coast to coordinate enforcement efforts and share information between the state and federal agencies about non-compliant companies.

Misclassifying workers is a mistake that can have devastating financial consequences for any business. Understanding the rules will help you structure your work agreements in advance to assure “independent contractor” status or allow you to properly assign worker status from the very  beginning.  Nobody likes surprises!