My New Worker:
Independent Contractor or Employee?

A statement we often hear from businesses is, 'We are just a small company and can't afford to hire employees." This statement touches on Chapter 1 of every payroll manual: Worker Classification. Worker classification is the process of determining whether your workers are independent contractors (IC's) or employees (EE's). While many see this as a decision with which they have some degree of license or a "gray area", tax agencies do not have the same view. Red flags involving worker classification can sometimes trigger an audit. In an audit, the first question you will be asked is to describe the nature of the relationship between your business and your IC. The penalties for misclassification are steep and involve your business paying for the misclassified person's back taxes. So, my question is: can you afford to take worker classification lightly?

There is a popular misconception that it costs less to bring on an IC than an EE. This probably stems from the fact that employers are obligated to pay employer taxes for their employees. In California, this can add about 10-15% to the cost of gross wages. And then there is workers' compensation insurance - another cost. In reality, the cost of an EE should actually be less than what you would pay an IC. True IC's have expenses which they factor into their rates. These expenses include [self-] employment taxes, insurance, and advertising, just to name a few.

To understand why IC rates would include such expenses, it helps to have a basic understanding of the key differences between IC's and EE's. Think of a plumber as a great analogy for an IC...

  • You pay them to do a specific job, for which there is a written contract.
  • They set the price, and can, potentially, lose money on the deal.
  • They use their own tools, and have a significant investment in being able to provide services.
  • There is no training involved, and, while you may provide specifications, you don't tell them how to do the job.
  • When they're done, you pay them a price for the job.
  • They perform the same services as a business for many other customers.
  • Their services are not a function of your business' regular operations.
  • They do not hire or manage your employees.

If your worker relationship is not like this example, it is probably an employee relationship.

But how would a tax agency ever find out if you had misclassified an EE as an IC? There are probably many ways they can do this. However, I am aware of two:

1. Your IC is laid-off and files for unemployment with the Employment Development Department (EDD - yes, the same agency that collects payroll taxes in CA). In the process, the EDD looks up your payroll tax returns and sees that your IC was not listed on any of them. The EDD explains to your IC that they were not an employee of your company. Your IC says, 'Yes I was. I worked for them from X to Y dates". An audit is triggered. This actually happens a lot more than you would think! It happened to a client of ours a few years ago after we had strongly urged them to seek legal advice when they told us they wanted to pay some IC's to do work for them. Two years of back taxes and penalties later, they owed more than $20,000!

2. The IRS and EDD conduct periodic audits, specifically to look for cases of misclassification. They have your 1099's, so they know when you have IC's. This actually happened to us several years ago. Fortunately, the people we paid and reported on Form 1099 were legitimate IC's!

Penalties for worker misclassification are steep! Penalties vary according to whether it is determined to be a case of intentional or unintentional misclassification. Here is a sample:

  • 20% to 100% of FICA (Social Security + Medicare) employees should have paid,
  • Plus, 1.5% to 20% of all wages paid to misclassified workers,
  • Plus, 100% of FICA employer should have paid
  • Plus, 100% FUTA that should have been paid
  • Plus, Up to 100% of withholding taxes that should have been deposited

There are also other possible penalties associated with misclassification, including multiple types of failure to file penalties, criminal charges, and imprisonment.

Based on the information presented above, it should be clear that all business should treat this subject with a high degree of importance. Some additional references are provided below. However, we strongly urge you seek the advice of a certified Human Resources Professional or Employment Law Attorney in making worker classification decisions for your business.

This is a great resource from the EDD
It takes a minute to install some Macromedia software, but it is worth the time.

Finally, this link on the IRS web site which contains info about IC vs. EE is.
Please make sure you go to each of the links that are in that article.