If you have ever prepared payroll then you are familiar with IRS Publication 15, the Employer’s Tax Guide. Just as important is Pub 15-A, the Employer’s Supplemental Tax Guide because this pub will help you to properly classify your workers as either employees or independent contractors.
The general rule for classifying workers as either employees or independent contractors rests on a three factor test but there are also many other factors that may come into play depending on your situation. Those other factors are beyond the scope of this brief discussion so do not rely or act upon this article, it is only intended as general knowledge, get a professional to help you. The three general factors are; the extent of behavioral control that you exert over the worker, the extent of financial control you enjoy, and the nature of the relationship. Pub 15-A goes further in helping you learn and determine the differences between employees, independent contractors, statutory employees and common-law employees. This is important because when a worker is incorrectly classified it is the employer that pays for the costly mistake.
A number of years ago we had a small-business client who owned some dump trucks as part of his construction business. Unbeknownst to us, this client was paying some drivers as independent contractors despite maintaining complete control over them. One of those drivers knew better and did something about it. At the end of the year that driver left his job for greener pastures. The following March our client received a notice from the IRS that he owed more than $10,000 in back payroll taxes, penalties and interest related to that driver. Best guess is that the driver completed and sent form SS-8 to the IRS, the IRS agreed, re-classified the independent contractor driver as an employee, assumed that all payments made to that driver were now paychecks net of taxes, and then sent our client the bill for the difference.
If you are not familiar with form SS-8 it is titled, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. If you are an employer, despite the instructions suggesting that you can allow the IRS to make your determinations for you, consider the consequences of telling the IRS that, “I run a business, have workers, and don’t know what I’m doing, won’t you please help me?” And they will. Allow me to paraphrase part of a decision written by a U.S. Tax Court judge, “To rely upon the IRS for advice is to do so at your own peril.” Get a paid professional to help you. Your CPA is the best place to start. If you plan on having a larger workforce, you will also want to involve HR experts and attorneys who specialize in labor law.
There was nothing that we could do about the taxes and penalties for our client. We are professional accountants, not TV miracle workers. Sometimes you have to pay for your mistakes and he was lucky it was only $10,000. The labor laws are not for the faint of heart, and if they are new to you then get help. The cost of the consultations will be a good investment compared to any payroll or labor-related pitfalls which can run into the millions of dollars.