Charles Read, CPA, USTCP, IRSAC
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This is a great question – How do I know when to classify a worker as an IC or W-2? – and one that many don’t know the answer to. Many think It may be cheaper to hire an independent contractor (IC) in business rather than employees (W-2) because the taxing and reporting requirements are much less costly.
IRS Common Law Rules
Under the IRS Common Law Rules, if the employer has the right to control what work will be done and how that work will be done, then an employer-employee relationship exists and the worker is a W-2 employee. However, as long as the work is defined by expected results, rather than how the work is performed, the individual is not classified as an employee under common law rules.
The IRS has created rules that will help you determine how to classify your worker. They have sought to streamline the process for determining whether a worker is an employee or an independent contractor by identifying those factors that most clearly indicate the degree of control (or independence) in the relationship of the worker and the business. There are three general types or categories:
- behavioral control,
- financial control, and
- the type of relationship between the parties.
Go to the IRS website to get the details on Common Law Rule categories.
Worker Misclassification and Audit Risk
The US Department of Labor estimates that 70% of employers misclassify workers.
The Department of Labor (DOL) calls out businesses on their misclassification news releases webpage.
The misclassification of workers as ICs rather than W-2s has led to substantial losses in revenue for the federal government. The failure to properly credit earnings for Social Security and unemployment benefit purposes, the IRS has focused more resources on Payroll Tax audits for worker misclassification.
When not if you are audited by your state Unemployment Department they will be looking for misclassifications. The taxes, penalties, and interest accessed can sometimes actually drive a company or individual into bankruptcy; be aware. Read this article on State audits for some audit examples.
If you are willing to put up with the aspects, attributes, advantages, and disadvantages of independent contractors go ahead and use them. Otherwise, your workers are classified as W-2 employees.
Learn more about the pros and cons of independent contractors and employees.
Mistakes can cost you, big time. We have had clients who have, before they were clients, pay tens of thousands of dollars out for misclassifications. It’s better to play it safe and properly classify your workers rather than cut corners and end up audited and fined.
IC or W-2 Resources
Check out our detailed infographic on the difference between independent contractors and employees.
Go to this IRS webpage for information describing the difference between independent contractors and employees.