Properly Classify Workers to Reduce Risk

A metal plating company relies upon independent drivers to transport its finished goods to customers.

A hydraulic equipment maker deploys a nationwide network of independent sales representatives to call upon prospects and existing customers. Using independent contractors for those and other functions enables manufacturers to operate more efficiently and avoid many of the costs, legal concerns and human resources issues associated with hiring, retaining and—if necessary—terminating employees. Those benefits allow companies to more quickly respond to peak production requirements, heightened competitive pressures, uncertain economic conditions or cyclical industry trends.

To the U.S. Internal Revenue Service and other federal and state regulatory entities, however, improperly classifying employees as independent contractors to attain those benefits could equate to evasion of withholding tax, Social Security tax, unemployment tax and other legal obligations. To realize the benefits associated with contract labor, manufacturers must ensure that such individuals meet the legal classification of an independent contractor.

Three considerations

While related rules are somewhat ambiguous, here are three general factors to consider before classifying someone as an independent contractor:

1. Behavioral control.  To properly classify a worker as an independent contractor and not an employee, an employer can direct and control the outcome of work, but not the way the work itself is done. The metal plating company, for example, can supply the truck driver with a customer address and delivery deadline. To properly classify that driver as an independent contractor, though, the company cannot define the delivery route or dictate when or where the driver takes breaks.

Likewise, the hydraulic equipment maker can forward customer and prospect lists to independent sales representatives. It can ask for periodic sales activity reports without jeopardizing the independent contractor classification. It could be a problem, however, if sales calls are scheduled for those representatives, or they are required to work defined hours at company-owned offices.

2. Financial control. An employer cannot control the financial and business aspects of an independent contractor. To be properly classified as an independent contractor, the truck driver must be at risk for making a profit or a loss. The driver must incur significant business expenses, such as costs for vehicle purchase, repairs and maintenance.

Independent sales representatives often work for several complementary but noncompetitive manufacturers at the same time. Such individuals with multiple customers most likely meet independent contractor classification, whereas the status of an individual with just one customer could be questioned.

3. Type of relationship. If a company provides various benefits, such as health insurance, participation in an employee stock ownership plan, or paid vacation to a truck driver, independent sales representative or other worker, it generally must classify that person as an employee. To be properly classified as an independent contractor, an individual must be responsible for securing such benefits independently.

In addition to those three factors, Section 530 of the Revenue Act of 1978 also allows employers to consider the following circumstances for properly classifying someone as an independent contractor:

• How long that individual has been classified as an independent contractor

• If individuals performing similar work for the company are classified as independent contractors

• Whether the employer has consistently met related compliance requirements, including timely filed 1099 tax forms.

Consequences for misclassifying employees as independent contractors can include liability for back taxes, interest and penalties, as well as back and front pay, attorneys’ fees, and compensatory and punitive damages. To realize the benefits of using independent contractors, employers must ensure that those workers truly merit that classification. 

Mark Walker, mdwalker@weaverandtidwell.com, is a Tax Partner for Weaver and Tidwell L.L.P.
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