Employees vs. Independent Contractors – Classify Correctly or Suffer the Consequences!

Small businesses often try to avoid the costs that come with hiring an employee. Hiring an employee means unemployment compensation, worker’s compensation, employment taxes and increased liability. All of these can be a serious drain on the small business.

Independent contractors can be a valuable tool to keep costs down in your business. However, there can be serious consequences for misclassifying an employee as an independent contractor.

For starters, you could receive 3 audits: the IRS, the Wisconsin Department of Revenue and the Wisconsin Department of Workforce Development. In addition to the audits, the monetary costs to your business are often astronomical — from back taxes, unemployment compensation and worker’s compensation payments, to penalties, fines and interest. Often, the end result is the end of your business.

To make it more complicated, there is no simple checklist to determine the correct classification of an employee versus an independent contractor. The IRS uses a 3-category test which balances various criteria for and against classification as an independent contractor. This test, however, is different from the test used for determining unemployment compensation coverage and the test for worker’s compensation coverage. Unfortunately, the rules are confusing and often conflicting. The answer depends, in large part, on how much control you exert over the worker as he or she fulfills the job requirements. The more control you exert, the more it looks like an employment arrangement.

Even if you think you’re following all the rules and innocently make a mistake with a misclassification, you may wonder how you could possibly get caught. Sometimes it’s simply the “luck” of the draw — you or your “independent contractor” can be randomly selected for audit. One of the most targeted areas of audits today is independent contractors. Often, however, getting caught is the result of a deteriorating relationship with the independent contractor. If the independent contractor files for unemployment compensation, worker’s compensation or a tax refund, you will inevitably receive a phone call or letter which will begin the inquiry.

So what should you do to protect your business? First, look at the tests and determine whether the worker really is an employee or independent contractor. If the worker is truly an independent contractor, use an Independent Contractor agreement to solidify that both parties understand the nature of the relationship. For example, include that the worker will operate under his own Federal Employer Identification Number, will use his own equipment, and will be paid per project. Such an agreement is often just the proof you need to satisfy the inquiring minds of the IRS, Wisconsin Department of Revenue and Department of Workforce Development.

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