Are some of your worker’s independent contractors instead of employees? Correctly classifying your workers will preserve the tax breaks that come with hiring independent contractors — and help you avoid major penalties.

Why it matters

Employers are required to withhold taxes for employees and pay the employer’s share of payroll taxes on wages. These amounts are reported to the IRS, as well as state tax obligations. An employer may also be liable for fringe benefits for eligible employees, like health insurance and matching 401(k) contributions.

Conversely, an employer doesn’t have to withhold or pay taxes on behalf of independent contractors. These workers take care of taxes, insurance, and other benefits on their own. This is why the IRS pays special attention to how workers are classified.

Control is key

Generally, the issue boils down to control. If an employer maintains behavioral and financial control over a worker, he or she should be treated as an employee. Independent contractors, on the other hand, have a high level of autonomy and independence over the work being performed.

Avoid misclassification

The stakes are high. If the IRS discovers a misclassification, it will assess back taxes for the tax years in question, plus interest and penalties. For an intentional error, criminal sanctions may be imposed.

Here’s what an employer can do to avoid the IRS challenging an independent contractor classification:

  • Understand the tax rules. If you exercise a great deal of control over workers, they are likely to be considered employees.
  • Be specific. Spell out the services to be performed by independent contractors, their responsibilities and the expectations in a written contract.
  • Keep work schedules flexible. Avoid setting a regular work schedule for independent contractors. Allow them the ability to set their own hours.
  • Maintain separate payment practices. Compensate independent contractors on a per-job basis. Don’t pay them a regular amount each payroll period, like you do employees.
  • Review work arrangements periodically. Request invoices from independent contractors before payments are made.
  • Be careful about benefits. You don’t need to cover independent contractors under a health insurance plan or provide other fringe benefits that are typically given to employees.

Keep in mind that an employer that has experienced misclassification issues may qualify for tax penalty relief if it can establish it has a reasonable basis for treating workers as independent contractors. This is based on various factors and past history. Back taxes and penalties may be waived if the employer has been consistent in its treatment.