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Independent Contractors vs. Employees: Potential Tax Pitfalls
By: Anjum Tunuli, Chief Tax Officer
Too many startups make their hiring decisions strictly based on cost. That’s understandable. In the early days, when funds are tight and cash flow is non-existent, it makes sense to watch every penny. But a myopic focus on wringing out every last cost can mean you miss the forest for the trees. It could also leave you vulnerable to tax and employment law violations. Before you make your next hire, here’s what to know about potential tax pitfalls related to classifying workers.
How you classify workers matters.
The distinction between employees and independent contractors is important, not just for your cost base and cash flow but also for your taxes. Going with contractors might seem to make sense. You don’t have to give them benefits, withhold payroll taxes, or pay the slew of other taxes and benefits you do for employees. But just calling someone a contractor doesn’t make it so. And misclassifying workers can land you in hot water.
What is the difference between an employee and an independent contractor?
Whether someone is an independent contractor or an employee boils down to whether or not you control the “manner and means” of their work. If you want “the legal right to control the details of how the services are performed,“ what gets done and when, then you’re looking for an employee, not an independent contractor.
What are the tax implications of hiring an employee versus an independent contractor?
Employees come with added costs versus contractors—above and beyond any benefits you offer such as healthcare coverage and vacation. These include (but aren’t limited to): mandatory payments for social security and Medicare (FICA) taxes, unemployment insurance taxes, state employment taxes, payments into federal and state workers compensation funds, and in some states, required sick leave.
While you don’t need to withhold payroll taxes for independent contractors, you do need to file 1099-MISCs (and provide copies to) any independent contractors who do work for you. You’ll also need to keep completed Form W-9s on file.
How big of an issue is this really?
Given the cost difference, it might be tempting to play fast and loose with these categories. But that could catch up with you. Federal and state agencies do regular employer audits. A disgruntled worker could file a complaint. If you get caught misclassifying workers as contractors instead of as employees, you could be forced to pay back taxes, major fines, and even, depending on the circumstances, criminal penalties to the IRS and the U.S. Department of Labor. And it’s not just the Feds. States have become increasingly aggressive with enforcement because of the amount of tax dollars on the line.
In New Jersey, the incoming governor recently created a task force to tackle employee misclassification. In California, the state Supreme Court just made it more difficult to classify workers as independent contractors. In Dynamex Operations West, Inc. v The Superior Court of Los Angeles County, the Court ruled that before they can classify a worker as an independent contractor, employers now have to prove the worker is:
- “free from the control and direction of the hirer in connection with the performance of the work;”
- “engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity;”
- “performs work that is outside the usual course of the hiring entity’s business.”
While the implications of the California case are still unclear, it could have wide impact. The complexity and uncertainty make it all the more important to work with experts, including HR and tax professionals, to make sure you get this right. You should also consult with your legal counsel to understand the specific requirements you are subject to.
Do you have more questions about employees versus contractors and/or how to manage your tax compliance? Contact us to learn how we can help you!
Anjum Tunuli is Early Growth Financial Services’ (EGFS) Chief Tax Officer. An accomplished tax executive, with over fifteen years of experience, he works with successful small to mid-sized companies and their owners. Tunuli also has a very successful track record representing taxpayers before various taxing agencies and helping clients understand the full financial impact of tax planning on their operations.