Employment vs. independent contractor

Q

I hire workers on a seasonal basis during my busy periods and treat them as independent contractors. This arrangement saves me payroll taxes, worker’s compensation insurance and administrative headaches. I usually employ them for no more than a month or two. Are there any potential problems with this arrangement?

A

Properly classifying a worker as an independent (outside) contractor may save your business money by avoiding payroll taxes, overtime pay and employee benefits, such as pension plan contributions, and health and workers’ compensation insurance. Generally, the only tax forms you would need to complete is the annual Form 1099-Misc for independent contractors paid $600 or more during the calendar year.

On the other hand, workers classified as employees require federal and state tax withholding, payroll tax expense and workers’ compensation insurance. Having employees will also require you to file quarterly and annual payroll tax returns. You will be responsible for knowing and adhering to the often cumbersome payroll tax depository and payment requirements. As the amount of your payroll increases, you may also be required to remit tax payments electronically.

The determination of whether a worker is an independent contractor or an employee is based on common law rules. The determination depends primarily on the extent to which you have the right to direct and control the worker with regard to what is to be done, how it is to be done and when it is to be done. An employer generally has the right to control how and when an employee performs the service. Independent contractors generally determine how and when the work is to be performed.

The Internal Revenue Service has developed guidelines falling into three categories to help discern the degree of control and independence to determine employee or independent contractor status: behavioral control, financial control, and the type of relationship of the parties (contractual, benefit package, etc.).

The exposure for misclassifying an employee as an independent contractor can be substantial. In addition to the state unemployment insurance and state withholding taxes, you will be responsible for the employer’s share of social security and Medicare taxes plus a percentage of the federal withholding taxes and employee’s share of social security and Medicare taxes that should have been withheld, plus interest and penalties. If the IRS determines that you intentionally misclassified your workers, or did not file Forms 1099-Misc, your exposure will be even greater!

If you determine that your workers are “employees” and not “independent contractors,” then you next must decide how to handle the administrative requirements of having a payroll. There are numerous computer software products available if you decide you want to administer the payroll inhouse. Another viable alternative is the use of an outside payroll processing company that can provide a host of services — generally, at a reasonable and cost-effective price.

Under the new tax law that became effective in 2018, you may be incentivized to classify your parttime workers as employees to enhance the Section 199A deduction.

Also, the new California Assembly Bill 5 signed into law during 2019 and effective Jan. 1, is a law that limits the use of classifying workers as independent contractors rather than employees by companies in the state. Employees are entitled to greater labor protections, such as minimum wage laws, sick leave, and unemployment and workers’ compensation benefits, which do not apply to independent contractors. Concerns over employee misclassification, especially in the gig economy, drove support for the bill.

To protect yourself, I recommend that you discuss this issue with your income tax return preparer as well as a labor law attorney.