Every business focusing on the US market will work at some point together with US persons to increase its local presence. The classification of this person as an employee or independent contractor has important consequences. Employers should amongst others withhold and pay income tax, social security and unemployment contributions. Employees on the other hand can be entitled to certain benefits.
While there is not one determining factor, the key element in classifying a worker as an employee or independent contractor is the level of control.
The factors determining classification can vary depending on the agency and jurisdiction and there is not one standard test. All circumstances should be considered and used to evaluate the level of control/independence of the worker. Below is an overview of the three main categories identified by the IRS to help determining the classification:
- Behavioral control: the right to direct or control how the work is performed. Instructions regarding when and where the work should be performed, evaluations and training may indicate an employee relationship.
- Financial control: the right to direct or control the economic part of the work. Working for one/multiple companies, expense reimbursement and payment method should amongst others be considered.
- Relationship control: what are the terms and how is this perceived by both parties. Any benefits offered by the company and the permanency of the relationship will be important, while a written description of the worker’s status might be an indication but is in itself not decisive.
Although working with independent contractors may sound attractive, misclassification can quickly turn into an expensive mistake.
Misclassification can have serious consequences and the degree of potential penalties depends amongst others on whether reasonable cause could be demonstrated. Apart from being liable for employment taxes, the responsible person could be held personally liable and the employer could face several penalties, including, but not limited to:
- Failure to furnish correct payee statements such as Form W-2 or 1099: $50-$270 per statement;
- Failure to withhold payroll taxes: 3% of wages, 40% of employee FICA taxes (social security and medicare) and 100% of employer FICA taxes;
- Failure to file: 5% per month during the period of failure to file employment tax returns, up to 25% of total tax liability;
- Failure to pay:5% of unpaid liability for each month up to 25% of total tax liability;
The above civil penalties can be significantly higher in case of substantial understatement of tax, or if fraud or willful misclassification is suspected. In addition, some criminal penalties may apply, including:
- Willful failure to collect or pay over tax: not more than $10,000 or imprisonment for not more than 5 years, or both;
- Willful failure to make statement to employees: not more than $10,000 or imprisonment for not more than 1 year, or both, for each offense.
Another important element is workers’ compensation insurance. In case a worker is classified as an independent contractor and gets injured/disabled while working, the company could face lawsuits as the worker would have received workers’ compensation benefits if he/she would have been treated as an employee.
The 2017 US tax reform Act: why it is important to determine the worker’s classification at the start of the relationship.
The nature of the relationship can vary over time and companies should reassess whether the initial determination is still valid. It may for example start with working on a specific project but may turn into an indefinite relationship. Afterwards reclassifying an independent contractor into an employee may however prove to be difficult; for example, it could impact impact an independent contractor’s “qualified business income” (QBI) deduction provided by the 2017 US tax reform Act, which allows certain independents contractors to take a tax deduction of up to 20% of them QBI (subject to certain limitations).
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This article only includes general information and IMS is not, by means of this article, rendering any tax, legal or other professional services. This communication should not be relied upon for any decision or action that may have an impact on your business. Prior to taking any action, you should be in contact with your advisor.