Managing employee payroll taxes can get quite complicated, with a number of areas being particularly opaque. One of those is the question of employee classification; is a person properly classified as a worker or an independent contractor?
Misclassifying workers as independent contractors carries with it some significant consequences, including penalties and even potential fraud prosecution, so it is a topic worth exploring in some detail.
Employee misclassification occurs where an employer classifies a worker as an independent contractor. This is sometimes done by mistake, but more often is an attempt by the employer to avoid the ancillary benefits that are payable to workers (which include benefits and protections such as sickness and unemployment pay) as well as the employment taxes that must be paid on their behalf.
The California Employment Development Department
The California Employment Development Department (EDD) is part of the Labor and Workforce Development Agency and has a wide mandate that includes collecting and administering employment-related taxes. They have the power to audit your company if they feel that you have misclassified workers in an attempt to avoid paying payroll taxes. In recent years, this has been a focus of the EDD and audits are common.
There are four separate classifications for workers: employee, independent contractor, statutory employee and statutory non-employee.
An employee is paid a regular salary and is afforded various state and federal protections in terms of their employment. Employers must pay state and federal income taxes on the employee’s behalf, and are liable for 50% of the FICA (Social Security and Medicare) taxes payable as well as the Medicare levy. State and federal unemployment taxes are also the employer’s responsibility, although in California, employees are responsible for state disability tax.
An independent contractor is a self-employed person who is hired to complete tasks for the company. They are liable for their own taxes, both income and self-employment tax, which covers social security and Medicare. There is no unemployment tax payable as self-employed contractors are not eligible to receive unemployment benefits.
Statutory employees are independent contractors who are treated as employees for tax purposes. This situation arises where a worker is self-employed and has a measure of control over their working hours and conditions, but does business principally with a single employer. For social security tax purposes they are treated as employees, but they do not receive employer benefits and employers do not withhold income tax.
Statutory non-employees are workers such as licensed real estate agents and direct sellers, where 90% of their income or more comes from sales commission rather than being tied to hours worked. Income tax is not withheld on their behalf. They must be designated as holding this status via a written contract.
Determining proper classification
A written contract stating that your worker is an independent contractor is not sufficient to establish that status. Whether a worker is properly a contractor or an employee requires a finding of fact based on the particular case at hand. Where there is a claim that a worker has been misclassified, the courts will look behind the paperwork and at three broad categories.
Behavioral ControlDoes the employer dictate when and when the work is to be performed and provide the tools and workspace in which it should be completed? Does the employer dictate which tasks have priority, monitor performance and provide workers with training? Where a worker is effectively under the supervision of an employer who controls the work process, they are likely to be classified as an employee.
Financial ControlDoes the worker set their own fee for the service or are they paid a regular wage which is similar each week? Is the worker making a financial investment in their own business, such as buying equipment, maintaining a marketing budget or hiring premises?
The RelationshipIs the relationship ongoing, or has the worker been hired for a specific project or time frame? Is the work to be performed of an integral nature to the company? Is the worker restricted from working for another company? Does a written contract exist?
While some misclassifications are unintentional, they accrue significant benefits to the employer at the expense of both state revenue and the rights of the worker. Employers are not required to pay payroll taxes on behalf of independent contractors and they are not eligible for unemployment or sickness benefits. That means that employers can save money by classifying their employees as independent contractors.
The EDD is concerned at the loss of revenue that results from improper classification, especially where workers are not paying income tax on their own behalf in the belief that their employer has withheld that money.
It also affords employers flexibility in only paying those workers for time needed, as opposed to a full time salary, as they do not enjoy the same legislative protections: this is particularly helpful for small or seasonal businesses.
Misclassifying employees as independent contractors can lead to substantial consequences including:
- Federal tax penalties that require employers to pay all of the employee's unpaid social security, unemployment, and income tax withholdings. Employers may also be assessed a penalty of $5,000 per misclassified worker plus 1.5% of the employee’s federal income tax liability plus 20% of the amount that should have been withheld for the employee’s social security taxes. These penalties can be reduced or waived if you can show that the misclassification was done in good faith - a tax expert can assist you in making this case.
- State tax penalties that require employers to either pay insurance, income and disability taxes or show that the employee has paid these in full. Failure to pay is a misdemeanor that carries a penalty of $1,000 and up to a year in prison.
- Breach of the requirements to keep time and other records, and to issue itemized wages statements, both of which carry lump sum penalties.
- Exposure for liability if a worker is injured on the job and workers’ compensation insurance has not been arranged; and
- Exposure for unfair business practices where a worker has been denied overtime, dismissed without notice or in other ways not enjoyed the protections that would normally apply to an employee.
Preventing future misclassifications
With some understanding of how workers should be classified, you will be in a stronger position to ensure that future misclassifications do not occur. However, if there is still doubt, you may file a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. This form goes to the IRS, who will issue a formal determination on that worker’s status.
Although the process takes up to six months, it can be very useful if you often hire workers who do similar jobs or under similar conditions as being strongly indicative of their status.
How a tax expert can help
If you are unsure whether your staff is properly classified, consider talking to a tax professional. They will be able to help you minimize your tax liability legally and without running the risk of penalties that flow from misclassification. If you have been assessed and found to have misclassified employees, a tax expert can help you prove that the misclassification was unintentional and seek a reduction in the penalties that may apply.