On July 20, 2017, the Internal Revenue Service ("IRS") issued a reminder for small businesses on the importance of correctly classifying workers as employees or independent contractors.1 Employers failing to do this correctly may face penalties, including trust fund penalties, from the IRS, which can be assessed not only against the employer but also against officers and directors. Classification is important because an employer must withhold income taxes and pay Social Security, Medicare taxes, and unemployment tax on wages paid to workers who are employees, but independent contractors are instead subject to self-employment tax.
Employers must look at the facts in each situation. The IRS has reminded small businesses to focus on three categories to properly classify workers: (1) behavioral control, (2) financial control, and (3) the relationship of the parties. A worker is properly classified as an employee if the employer exercises significant behavioral and financial control over the worker such as controlling the manner of work by giving the worker instructions or training and providing the worker with the tools necessary to complete the work. Also, if the employer and the worker have a permanent working relationship and the employer provides the worker with benefits such as a pension plan or vacation pay, the worker properly would be classified as an employee. On the other hand, a worker should be treated as an independent contractor if the worker has autonomy on deciding the manner of work and amount of hours to work, works for multiple employers, or does not retain a permanent relationship with the employer. These factors all reflect a 20-factor test established by the IRS in Revenue Ruling 87-41.2
Some employers may be able to avoid penalties or obtain partial relief if they can provide a reasonable basis for not treating a worker as an employee or are eligible for the Voluntary Classification Settlement Program. However, employers should be aware of the Trust Fund Recovery Penalty.3 Employers that fail to properly classify workers as employees may become subject to the penalty for willfully failing to collect and pay employment taxes. Willfully does not necessarily mean intentionally; the employer could have been plainly indifferent to its requirements. The penalty is equal to the amount of the unpaid income taxes withheld plus the employee's portion of Social Security and Medicare taxes. Furthermore, the penalty can be assessed against any individual person responsible for collecting and paying withheld income and employment taxes such as an officer or director of a corporation, a member of a board of trustees of a nonprofit organization, or any person with authority and control over funds to direct their disbursement.
1 Understanding Employee v. Contractor Designation, IRS Fact Sheet 2017-09 (July 20, 2017), available here.
2 Revenue Ruling 87-41, 1987-1 C.B. 296.
3 See IRC § 6672.