One mistake startups make, particularly in the tech sector, is to misclassify employees as independent contractors. Employees come with costs – tax withholding; paying Social Security, Medicare and unemployment taxes; overtime (where appropriate) and even benefits – that are absent with independent contractors.
The IRS emphasizes that if the business controls what work is accomplished and directs how it is done, it exerts behavioral control. If the business directs or controls financial and certain relevant aspects of a worker’s job, it exercises financial control. This includes:
- The extent of the worker’s investment in the facilities or tools used in performing services
- The extent to which the worker makes his or her services available to the relevant market
- How the business pays the worker, and
- The extent to which the worker can realize a profit or incur a loss.
The IRS also looks to the nature of the relationship and how each side views it. This includes:
- Written contracts describing the relationship the parties intended to create
- Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation or sick pay
- The permanency of the relationship, and
- The extent to which services performed by the worker are a key aspect of the regular business of the company.
- The extent to which the worker has unreimbursed business expenses.
While it may not always be black or white, the general rule is that the greater the control the would-be employer exercises over the individual the more likely it is that he or she is an employee. A list of the IRS’ 20 factors considered is below.
Here is an example provided by the IRS:
Steve Smith, a computer programmer, is laid off when Megabyte, Inc., downsizes. Megabyte agrees to pay Steve a flat amount to complete a one-time project to create a certain product. It isn’t clear how long that it will take to complete the project, and Steve isn’t guaranteed any minimum payment for the hours spent on the program. Megabyte provides Steve with no instructions beyond the specifications for the product itself. Steve and Megabyte have a written contract, which provides that Steve is considered to be an independent contractor, is required to pay federal and state taxes, and receives no benefits from Megabyte. Megabyte will file Form 1099-MISC, Miscellaneous Income, to report the amount paid to Steve. Steve works at home and isn’t expected or allowed to attend meetings of the software development group.
IRS Verdict: Steve is an independent contractor.
Getting the employee/contractor status wrong has consequences as it can lead to enforcement actions by both state and federal labor and taxing authorities or lawsuits by misclassified contractors. Offending companies can end up paying substantial penalties, back taxes, wages and attorneys fees.
The IRS can help employers determine the status of their workers by using form Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
Here is a useful video on this point from Mahalo.