What you need to know about classifying workers, Part I

Classifying workers for tax purposes is like trying to see through a glass of chocolate milk. That unclear outlook can leave employers operating in a very dangerous area. That’s because misclassification can bring the wrath of the IRS, the Department of Labor, and the National Labor Relations Board.

And that wrath can include financial penalties that can cripple a business.

Unfortunately, misclassification and the ensuing consequences are all too common. So, for the next two weeks, we’ll look at types of workers, how to classify them correctly, and where to get help when it gets confusing.

Let’s go!

Misclassification consequences

Classifying workers as independent contractors is tempting because it can reduce payroll tax burdens.

But it can also lead to wage law violations, unpaid employment taxes, unemployment insurance shortfalls, and unpaid workers’ compensation premiums. And when one government agency catches wind of a potential violation, the others are likely to start looking, as well.

They all have various tests to measure classification, and failing, as mentioned earlier, can be quite expensive.

The first step in avoiding these problems is to understand the types of workers as defined by the IRS. Then, you have to apply common-law rules to try and finalize a determination.

This week, we’ll focus on types of workers.

Types of employees

The IRS outlines four types of employees most businesses deal with: independent contractors, common law employees, statutory employees, and non-statutory employees.

They apply rules to each type to determine the differences.

For independent contractors, the IRS applies a general rule. It states that “an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”

For common-law employees, the opposite holds true. If you can control the work and how it will be done, then an employer-employee relationship probably exists. Of course, you still have to apply common-law rules to be sure. More on that next week.

Statutory employees are a little different. These might be independent contractors under common law rules, but they might still have to be treated as employees by taking out Social Security and Medicare taxes. Determining a statutory employee is a post unto itself, but the IRS does a good job of explaining the nuances here.

Suffice it to say in this post that statutory employees tend to be drivers who distribute non-milk beverages and non-food items—home assembly workers, life insurance agents, and traveling salespersons round out the list.

Statutory nonemployees tend to be direct sellers, licensed real estate agents, and some companion sitters. Direct sellers and real estate agents are considered self-employed if they meet two criteria.

First, all their payments must be related to sales or something other than hours worked.

Next, their services must also be performed under a written contract that states they won’t be treated as employees for federal tax purposes.

The Bottom Line

There’s a lot to know about types of employees, and the stakes are high. So, if in doubt, it’s best to seek guidance from a business attorney. But before you do, there’s still more to learn. Our next post will look at how to apply common law rules to the different types of workers so you can avoid misclassification.

See you next week!