Contractors vs. Employee – What is the Correct Classification?August 23, 2018
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In our article Contractors vs. Employee – What is the Correct Classification we discussed factors that are considered when making a classification. This article provides examples of the most common mistakes employers make regarding worker misclassification:
- The employer has the individual complete a W-9 and automatically assumes the individual is a contractor without considering the factors of an employee-employer relationship. This generally occurs with small businesses, start-up companies, or with employers with high employee turnover.
- The business owner hires a friend/relative or hires a friend/relative of an employee but the individual is not placed on payroll. Instead, the individual is classified as an outside contractor, vendor, or the like. The intention of the business owner may be to help the individual financially. However, when the relationship ends, either because the project was finished or the number of jobs decreased, the friend or relative tends to file for unemployment benefits if he or she cannot acquire future employment anywhere.
- An individual receives a W-2 and 1099 from the employing unit. An individual cannot be both an employee and independent contractor. This mistake usually occurs when the employer does not consider new hires to be employees until after a probationary period. However, all remunerations, including those earned during probation, are to be reported as W-2 wages.
To illustrate, an employee performs administrative services during business hours but also performs janitorial work during nights or weekends. The employee receives a payroll check for the administrative services but receives a handwritten check for the janitorial services. This is a problem because any and all payments to an employee, including payments for moonlight services, should be reported as wages to the appropriate government agency.
- The employing unit has the employee sign a written agreement. A written agreement in itself does not determine the employment relationship. An employer may request an individual to read and sign a document stating that the individual is an independent contractor and not an employee of the company. However, government agencies will look at the actual working relationship of the parties to determine if the relationship is that of an employer-employee or independent contractor based on the preponderance of the evidence and not simply on the intent of the parties to create an independent contractor relationship.
Written agreements may even contain behavioral and financials controls which can lead to an adverse result for the employing unit when a copy of the agreement is provided and reviewed by a government representative.
Procedures to Protect Your Business
As a business owner, you can and should implement procedures to protect your business from tax assessments, penalties, and interest due to worker misclassification. Below are some simple but effective procedures to implement:
- Only utilize contractors who have an established and registered business and submit invoices for services, such as a corporation, partnership, LLC, etc. Also confirm the business entity of individuals operating as sole proprietors because sole proprietors can be the most problematic when it comes to unemployment benefits. The Arizona Corporation Commission and the Arizona Registrar of Contractors are great resources when verifying business entities.
- If the sole proprietor, or any other business entity, has a business card, flyer, or other form of advertisement; then please keep a copy in your files for future reference, including printouts of online and or social media advertising such as Facebook, LinkedIn, Google, Yellow Pages, etc.
- If your company experiences high worker turnover, then utilize the services of a staffing agency to provide the labor and pay the staffing agency directly for the service as opposed to paying the individual(s) rendering the labor service. The employing unit who remits payment to an individual for services is liable for tax and insurance withholdings; thus, considered to be the employer.
It may be tempting to classify an individual as an independent contractor to reduce or avoid paying the related payroll tax expense but the penalties and fines from misclassification may far exceed the payroll tax liability. If you currently utilize independent contractors, it is imperative that the independent contract relationship is revisited before it is too late. It only takes one unemployment benefit claim for a government agency to start to question the relationship and the request for both financial and non-financial information begins, including the possibility of a three year audit.
Fredy Hernandez is an experienced field auditor formally with the State of Arizona – DES Unemployment Insurance Tax and now works as a financial and tax accountant at Morrison, Clark & Company CPAs, Chandler, Arizona. For more information, call (480) 424-7855 or visit morrisonclarkcompany.com.
This work is also published as Hernandez, F., Employee vs. Contractor: What is the correct worker classification? Construction Accounting and Taxation 28, no. 5 (2018).