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Worker Classification II: IRS Rules

This entry is for business owner/managers and their lenders.

Common with small businesses, and even mid-size businesses, is a lack of understanding of the IRS rules about something as fundamental as hiring workers. Must you hire as an employee or can you hire as a contractor?

If the business owner goes with what makes sense, well, that is a huge mistake. One cannot assume that the IRS rules will make sense. And it is not always their fault, as they are implementing laws passed by congress. Do they always make sense?


The difference it makes

If the IRS determines that employees were improperly classified as contract workers, they can assess back taxes and penalties. Since there is statistical evidence that up to 30 percent of workers who are not issued either W-2s or 10999s do not report either all or a portion of their income, this entire issue is on the IRS radar.

And an employee improperly classified as a contractor can apply for unemployment, worker’s compensation for injuries and for social security. At that point, the business has a fight on it’s hands to prove they reasonably classified the individual as a contractor.


IRS Rules relate to Independence and Control

The links in this section go right to the IRS website for further clarification. Facts that provide evidence of the degree of control and independence fall into three categories:

  1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
  2. Financial: Are the business aspects of the worker’s job controlled by the payer? (These include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
  3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor.

There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.

The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.


Written agreements are not enough

Lest you think that simply having a worker sign that they are an independent contractor is enough, think again. While that is important, it will not be sufficient to prove the worker is not an employee.


Can they lose money?

One of the best defenses against a position that a worker is truly is an employee is if they can lose money. If they bid the job wrong, for example, and they get paid less than their out-of-pocket cost, that would be a clear signal that they are a contractor.


What a lender might do

This decision is important and has significant ramifications. If your business borrower makes significant use of contracted services, you might do them (and yourself) the favor of checking in as to whether they have recently reviewed that status. Give them the IRS link. Not only might might you save them a lot of trouble, but if they are wrong and would have gotten caught, you may save your loan.


IRS Safe Harbor Rules

In the next post we’ll cover the Safe Harbor Rules. These provide relief to a business that had a reasonable basis for the classification of a worker as a contractor.

About the Author
Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis. She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans. Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.