There really is more to a name: employee classifications matter

Full time.  Part time.  Contract.  Companies spend dollars on each of these workers.  And while a dollar is a dollar to a budget, the distinction between these employment classifications may soon prove costly for employers who do not abide by the rules.

In its proposed budget for the 2011 fiscal year, the Department of Labor is allocating $25 million for a joint initiative with the Department of the Treasury to hire investigators to target employers who misclassify labor definitions.

The opportunity to hire contract labor versus adding internal headcount can be financially attractive to employers.  Companies are not responsible for withholding income taxes, paying Social Security, or contributing to workers’ compensation and unemployment insurance for independent contractors. Those expenses are the responsibility of the freelance worker.

If you classify an employee as an independent contractor and have no reasonable basis for doing so, you may be held liable for employment taxes for that worker in addition to potentially sizable fines.

Surprisingly, there is not a universal definition of an “employee”. The standards vary across state including federal statutes affecting taxes, discrimination, pay and benefits.

But generally speaking, the determination of whether someone is an employee hinges on how much control he or she has over required tasks and the extent to which the person is exposed to financial costs and risk.

IRS Guidelines
The IRS shares the following six tips for employers which clarify the contractor versus employee definition:

  1. Three characteristics are used by the IRS to determine the relationship between businesses and workers: Behavioral Control, Financial Control, and the Type of Relationship.
  2. Behavioral Control covers facts that show whether the business has a right to direct or control how the work is done through instructions, training or other means.
  3. Financial Control covers facts that show whether the business has a right to direct or control the financial and business aspects of the worker’s job.
  4. The Type of Relationship factor relates to how the workers and the business owner perceive their relationship.
  5. If you have the right to control or direct not only what is to be done, but also how it is to be done, then your workers are most likely employees.
  6. If you can direct or control only the result of the work done — and not the means and methods of accomplishing the result — then your workers are probably independent contractors.

Recommended Steps
Don’t just assume your employee classifications are in good shape.  Some possible action steps include:

  • Periodically review your employee roster by job category and check it against the recommended IRS guidelines.
  • Conduct a financial audit of monies paid to independent contractors.  Determine if the amount could raise a possible red flag to an third party’s review.
  • If you have independent contractors engaged, review their tasks against the IRS guidelines.  Ensure there is no potential that the tasks could easily be performed in-house.
  • Review independent contractor contracts to ensure consistency and clarity of terms.

This issue may not apply to your organzation today.  Perhaps you do not currently employ independent workers.  If and when that need arises, ensure you proceed correctly.

The additional focus from the Department of Labor won’t take effect until next year which gives employers time to reach compliance.  An investigation avoided is always your best course of action.

Some Helpful Resources
http://www.irs.gov/businesses/small/article/0,,id=99921,00.html
http://sbinfocanada.about.com/od/taxinfo/a/contractor1.htm
http://www.workforce.com/section/00/article/27/00/43.php

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