During September’s National Small Business Week—an annual celebration of small-business entrepreneurs—the Internal Revenue Service (IRS) reminded small business owners, inter alia, of their obligation to correctly classify workers either as employees or independent contractors. See here. Significantly, the IRS also prompted small business owners to be aware of its Voluntary Classification Settlement Program (VCSP), discussed below, which provides favorable treatment to an employer which comes forward voluntarily to report that it has wrongly classified workers as independent contractors, so long as it meets certain criteria.
A business has critically different tax obligations for employees or independent contractors: It must withhold income taxes and pay Social Security, Medicare, and unemployment taxes on an employee’s compensation, which it reports on IRS Form W-2. In contrast, a business reports payments to an independent contractor, who is considered self-employed, on IRS Form 1099, and the independent contractor pays quarterly estimated income taxes and self-employment taxes including Social Security and Medicare. A business that misclassifies employees as independent contractors without a reasonable basis may be liable for current and past employment taxes including interest, as well as potential penalties.
The IRS news alert recapitulated that—while there is no bright line—generally an employee provides services to a business that has the right to control what the worker will do and how that work will be done. Independent contractors offer services to business owners while maintaining control over these key aspects of their work. Three central considerations are:
- Behavioral control – Does the business control details of when, where, and how a worker works, control equipment or supplies that a worker uses, and/or provide job training? If so, this may be evidence that the worker is an employee.
- Financial control – If a business pays a worker per project or a flat flee rather than a regular wage—so the worker has individual profit (or loss) and the right to pursue other business opportunities—this is evidence that the worker is an independent contractor.
- The parties’ relationship – Are a worker’s services key to a business’s regular operations? Is the relationship expected to be ongoing? Does the business provide benefits like health insurance or a pension plan? All of this evidences employee status.
Under the VCSP, business owners who have, for three prior years, filed Forms 1099 for workers who should have been treated as employees can properly reclassify these employees going forward, pay 10% of the employment tax liability for the most recent tax year, and avoid interest and penalties and an employment tax audit for prior years. A crucial requirement, however, is that when the business seeks to take advantage of the VCSP, it may not be under an IRS employment tax audit or Department of Labor audit concerning worker classification.
For more information about properly classifying workers, and/or eligibility for and how to participate in the VCSP, contact Kostelanetz & Fink attorneys.