Question: We are currently downsizing as part of our company reorganization and are considering redesignating some of our employees as independent contractors. Are there any potential ramifications for making the change?
Answer: It is possible to change a worker's status from employee to independent contractor only if the worker meets the legal requirements for independent-contractor status. Whether a worker is an employee or an independent contractor is determined through legal tests established by state and federal courts and agencies.
For federal tax purposes the IRS applies common-law principles that examine facts about the degree of control the company has over the worker and how independent the worker is in performing the work. The greater the employer's control over how, when, and where the work is done, the more likely a worker will be classified as an employee. No single factor is determinative; the classification is based on the totality of the circumstances.
Other federal and state tests look at similar factors, although they may weigh particular factors differently. For comparison, federal courts and the U.S. Department of Labor generally use an economic realities approach to determine whether a worker is an employee under the Fair Labor Standards Act.
Because classification affects wages, tax withholding, benefits, and protections, employers should review each worker's status carefully. For guidance on how independent-contractor relationships typically differ from employer-employee relationships, see Understanding Independent Contractors for Small Businesses.
Employee misclassification is a major enforcement priority for federal and state agencies because misclassified workers may be denied protections such as minimum wage, overtime, leave, anti-discrimination protections, unemployment insurance, workers' compensation, and employer-provided health coverage.
Misclassification can also expose an employer to payroll tax liabilities and penalties. When agencies audit or investigate, they often examine worker classifications for multiple prior years and may reclassify payments made to contractors as wages.
Federal tax penalties
- $50 for each Form W-2 that should have been filed because of classifying workers as independent contractors.
- Penalties for failing to withhold include a percentage of wages and portions of Social Security and Medicare (FICA) taxes that were not withheld, plus the employer's matching FICA responsibilities, with interest accruing on unpaid amounts.
- A failure-to-pay penalty equal to 0.5 percent of the unpaid tax liability per month, up to 25 percent of the total unpaid tax.
- $50 for each failure to obtain a required Social Security number for a worker.
If an agency suspects intentional misclassification or fraud, additional fines and potentially criminal penalties may apply. State authorities can also impose penalties, interest, and other sanctions; some states have specific statutes and fines directed at misclassification.
Employers should also consider practical implications beyond taxes and wages, such as increased exposure to worker safety and liability claims and the effect on company benefit programs. For an example of how insurance can differ for independent contractors in a specific sector, see Independent Bus Contractor Insurance.
Because the consequences can be severe and vary by jurisdiction and circumstance, employers are strongly encouraged to review worker classifications carefully and seek professional advice when uncertain. You can also talk to an agent to discuss insurance and related risks with a licensed professional.
Frequently Asked Questions
How do agencies decide if a worker is an employee or an independent contractor?
Agencies apply multi-factor tests that assess control, independence, and the economic reality of the relationship; decisions are based on the totality of the circumstances.
What are common signs of misclassification an employer should watch for?
Signs include directing the worker's daily tasks, providing equipment, supervising hours, and lacking a contract that reflects true independent status.
Can misclassification lead to tax audits?
Yes; misclassification can trigger audits by the IRS and wage-and-hour investigations by federal or state labor agencies, which may assess back taxes and penalties.
What immediate steps should an employer take if unsure about a worker's status?
Document the working relationship, review applicable tests, and consult a tax, employment, or insurance professional before changing a worker's classification.