When hiring a new worker sometimes it is tempting for the employer to classify that worker as an independent contractor. It is cheaper for the employer because employment taxes do not have to be paid, certain benefits do not have be extended, additional insurance may not have be acquired. Also the employer may not have to comply with labor laws, like wage and hour, overtime, meal and rest periods.
So it is tempting to go ahead and classify that new worker as an independent contractor. But doing so may get you in trouble. Government agencies would rather you classify workers as employees for the very reasons just listed. The IRS and state revenue agencies would like for you to pay the employment taxes. They lose countless amounts of money each year to underreported self employment income. What better way to combat that then to have you pay these taxes upfront each pay period? California’s Deparment of Industrial Relations (labor department essentially) would also like to cover all workers with the broad labor laws in place.
So it’s a battle between you and the government. You want independent contractors. They want employees. So what do you do? You examine each classification carefully for each worker. You keep a detailed folder of such determinations and document everything that will support your classification of a worker as an independent contractor. And you must do this for several different agencies. IRS, California Franchise Tax Board, previously mentioned DIR.
The IRS does have a safe harbor, Section 530 of the Revenue Act of 1978:
1. Classifying the individual as an independent contractor is supported by judicial precedent, published rulings, a technical advice memorandum issued with respect to the taxpayer, or a letter ruling issued to the taxpayer.
2. A past employment tax or other IRS audit resulted in no assessment of employment taxes for improperly classified employees in substantially similar positions.
3. The independent contractor classification is supported by a long-standing and recognized practice in a significant segment of the taxpayer’s industry.
You must be very clear if you think you qualify for the safe harbor and the procedures must be followed precisely for the safe harbor to apply.
The IRS has a nice publication discussing worker classfications. Visit the DIR for labor relatedclassification discussion.. Finally, the Employment Development Department has an excellent handbook discussing this topic for California companies.
