Back To Top

Classify carefully: IRS continues to scrutinize independent contractors

The classification of workers as independent contractors or employees has significant implications for businesses, but especially for construction companies given the widespread use of subcontractors. This article reviews the differences between independent contractors and employees, and how the IRS evaluates the distinction.

The classification of workers as independent contractors or employees has significant implications — both tax and nontax — for all businesses. But this issue is particularly important for construction companies, given the widespread use of subcontractors in the industry.

In recent years, the IRS has been cracking down on employers that misclassify employees as independent contractors, and the consequences can be costly. Although the agency’s enforcement efforts won’t likely be in full force this year given the unfortunate development of the coronavirus (COVID-19) crisis, you can never be too careful.

Advantages of status

As you’re probably aware, treating a worker as an independent contractor provides significant advantages for employers. You avoid costs associated with withholding and remitting federal income and payroll taxes, as well as paying the employer’s share of payroll taxes. Employers may also avoid state income tax withholding, unemployment tax, workers’ compensation and disability insurance requirements.

In addition, independent contractor status relieves an employer of obligations to:

  • Provide employee benefits,
  • Pay minimum wages or overtime, and
  • Verify a worker’s eligibility to work in the U.S. (by completing Form I-9).

From a worker’s perspective, independent contractor status is often a disadvantage because he or she is ineligible for certain employee benefits and protections. But, for some workers, the qualified business income (QBI) deduction may provide an incentive to be treated as a contractor. (See “Independent contractors and the QBI deduction” on page X.)

Consequences of misclassification

There’s a widespread misconception that the IRS and state tax authorities won’t challenge the classification of a worker as an independent contractor if the employer files Form 1099 and the worker meets his or her tax obligations. But the reality is that tax agencies would rather deal with employees than independent contractors because it’s generally easier to collect taxes from a single employer than from many independent contractors.

If the IRS reclassifies an independent contractor as an employee, harsh consequences may follow. You could be held liable for back taxes — including income taxes that should have been withheld, and both the employer and employee shares of payroll taxes — plus penalties and interest. Notably, you can incur penalties even if the worker met his or her tax obligations as an independent contractor.

In addition to having to pay back taxes, you might also be exposed to claims by misclassified employees for employee benefits, minimum wages or overtime, as well as penalties for failure to meet I-9 requirements.

Issues to evaluate

Whether a worker is properly treated as an employee or independent contractor depends on the facts and circumstances of each case, but certain factors are critical to the determination. The IRS typically examines details within three categories:

1. Behavioral control. Generally, the more control the employer has over what a worker does, and how and when he or she does it, the more likely the worker is an employee. Factors to examine include the level of training and instruction provided, control over when the work is performed, and the existence of performance evaluation mechanisms.

2. Financial control. The more control the employer has over the economics associated with a job, the more likely the worker is an employee. Employees tend to use their employers’ equipment, get paid based on the number of hours they work, get reimbursed for their expenses, and receive paid time off and other perks. Independent contractors typically have their own equipment, pay their own expenses, and can experience profit or loss on jobs. Often, they’re paid a flat fee rather than an hourly rate.

3. Nature of the relationship. Employees are more likely to be hired indefinitely and to work for a single employer. Independent contractors are often engaged on a project basis and typically offer their services to multiple customers. Workers entrusted with key business functions are more likely to be considered employees.

Some states have enacted laws that govern the classification of workers. A recently enacted California law, for example, provides that a worker can’t be classified as an independent contractor unless he or she performs work that is “outside the usual course of the hiring entity’s business” and meets certain other requirements.

An ongoing issue

Whether a given individual is an independent contractor or employee is an ongoing issue that has challenged employers for years. To avoid or minimize liability for back taxes, back wages and penalties, general contractors should regularly reexamine their relationships with subcontractors — especially any used regularly or for long-term projects. Your CPA can help you assess whether you’re at risk from the IRS or a state tax authority. 

Sidebar: Independent contractors and the QBI deduction

The Tax Cuts and Jobs Act added Section 199A to the Internal Revenue Code. It allows sole proprietors and owners of pass-through entities who meet certain requirements to deduct up to 20% of their qualified business income (QBI). Because the deduction is available to independent contractors but not to employees, it may provide an incentive for some workers to be treated as independent contractors.

Given the potential loss of tax revenue from both the employer and the independent contractor who claims the QBI deduction, you can expect the IRS and state tax authorities to scrutinize these relationships closely. And think twice before converting an employee to an independent contractor: IRS regulations generally provide that an employee who’s subsequently treated as a non-employee while performing substantially the same services is presumed to be an employee, for purposes of the QBI deduction, for three years after the conversion. (This presumption may be rebutted with evidence that the worker is performing services as an independent contractor.)