Independent Contractor or Employee?

A business owner often struggles with the decision of whether someone who performs services for the business should be treated as an independent contractor or employee.  It is an important distinction that can have significant financial repercussions if improperly classfiied as an independent contractor.

The reason a business owner would want to categorize someone as an independent contractor is understandable. It saves money, time and provides simpicity.  Moreover, the individual providing the service might also like that designation believing that by being "in business" allows him to take advantage of a whole host of deductions. Sounds like a win-win situation, right? Wrong, it can be a ticking time-bomb just lying in wait.
 
This is an area of tax law that the IRS aggressively audits and litigates.  The key issue is which party exerts the most control or influence over the relationship. The more control and influence the business owner exerts the more likely you have an employer-employee situation.
 
Over the years the IRS has developed 20 common-law factors to determine, on a case-by-case basis, whether someone is an employee for IRS purposes.  Unfortunately there is no way to objectively score the 20-factor test and know with certainty how someone will be treated.  I would suggest thinking about the factors as weights on a scale. There more you stack up on one side the more likely the result tilts in that direction.
 
The cost of having the IRS recharacterize the relationship from an independent contractor to an employee can be devastating.  The business owner will have to pay employment taxes, penalties and interest which, over time, can be staggering. Moreover, if the employer has a retirement plan a reclassified employee might be entitled to a retirement plan contribution.

The IRS does provide relief in limited circumstances called Section 530 relief.  You have to show that 1) you have always treated the worker as an independent contractor, 2) you have filed all relevant returns and forms consistent with that classification and 3) that you have a reasonable basis for treating them as an independent contractor. Reasonable basis is based upon judical precedence, industry practice or prior IRS audit. It has become fairly difficult to demonstrate reasonable basis and I wouldn't rely upon Section 530 relief.
 
The laws surrounding the employee versus independent contractor issues are extremely complex and the stakes are high. I recommend that you consult with me about this issue.



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