When President Obama signed the recent finance reform bill he announced his hope that the bill would help foster innovation, not hamper it. “It is designed to make sure that everyone follows the same set of rules, so that firms compete on price and quality, not tricks and traps,” he said. He could just as easily been talking about worker classification.
Independent Contractor or Employee?
Classifying workers as either independent contractors or employees was never an easy task and to be perfectly frank, one that has not been given a lot of attention in some organizations. This is unfortunate because the Internal Revenue Service (IRS) has announced a 30-plus-percent increase in audits and is focusing on three areas, one of which is worker classification. Even as a senator, this was a pet issue for President Obama.
Not everyone realizes that the determination of whether a worker is an employee or an independent contractor is based on what the law says, and is not based on the wishes of one or both of the parties involved in the relationship. The most problematic situation in the corporate world revolves around a departing employee who is immediately rehired as a consultant on an independent-contractor status. While this may be fine with the consultant and the organization, if the individual is doing the same work in the same office under the same conditions, the person is still considered an employee under IRS guidelines.
The Consequences for Misclassification
As you might expect, there are serious financial implications should your organization get the classification wrong. Your company may have to pay some or all of the following:
- Penalty equaling a percentage of wages paid to misclassified workers;
- Federal Unemployment Tax Act (FUTA) that should have been paid;
- Both employee and employer Federal Insurance Contributions Act (FICA);
- Federal income taxes that should have been withheld but weren’t; and
- Late deposit penalties.
What’s the Big Deal?
A report by the Treasury Department's inspector general found that misclassified workers account for a significant portion of the tax gap (taxes not paid). Combine this simple fact with the IRS audits focused on the classification issue and the burgeoning deficit and it becomes clear that it is only a matter of time before action is taken.
It is critical that Corporate Finance readers who have more than a few independent contractors on their payroll take a closer look at these relationships and make sure they conform to the IRS’s guidelines.