It has become common for companies in the "gig economy," like Uber and the now defunct HomeAway, to classify and pay its workers as contract employees rather than traditional employees. The advantages are clear: you don't have to pay payroll taxes, benefits or workers compensation insurance for contract employees.

But misclassifying employees is becoming an expensive headache for many business owners.

Aside from the labor laws that you may be violating if you incorrectly classify your workers, the IRS is aggressively pursuing companies in order to collect back Social Security and Medicare taxes for misclassified employees. Misclassifications can cost you significant fines and penalties.

The employer portion of the Social Security tax (OASDI) is 6.2% and the Medicare tax is 1.45%. In addition, there is the federal unemployment tax and the state unemployment tax that can be more than 10% depending on your state. Workers compensation insurance also varies from state-to-state.

Classifications are primarily related to the degree of control and independence. The following are some IRS indicators that your worker is, in fact, an employee.

  1. Behavioral: You control or have the right to control what the worker does and how the worker does his or her job. You have have the legal right to control the details of how the job is performed.
  2. Financial: You control the business aspects of the worker's job. For instance, you determine how the worker is paid, whether expenses are reimbursed, and you provide tools and supplies.
  3. Type of Relationship: If there is a written contract and/or the worker has employee-type benefits such as a pension/retirement, health benefits and insurance, vacation pay, and/or access to employer vehicle and if the worker is performing a key aspect of the business.
  4. Training: You trained the employee to do the job a specific way.

Here are some indicators that your workers are contractors:

  1. Behavioral: You have the right to control or direct only the result of the work and not what will be done and how it will be done.
  2. Financial: The business aspects of the worker's job are controlled by the worker (including how he or she is paid, whether expenses are reimbursed, and the worker provides his or her own tools/supplies, etc.) The contract employee makes a profit or loss as a result of his/her work, aside from the money earned from the project with you.
  3. Type of Relationship: If you have a contract in place with a worker for a specific job and specific period of time, the worker may be contractor. You pay no benefits to the worker.
  4. Investment. The contract worker may have an investment in their own equipment and facilities used to do the work. For example, they may provide their own office, computer, and other equipment.
  5. Multiple employers. If your worker also works for other businesses, he/she may be a contractor. This is not conclusive since an employee can also work for more than one employer.
  6. Business Establishment: Contract employee may have payments issued to a business entity they formed rather than their individual name, ie., LLC, S corporation, etc.
  7. Training. Contract employees are usually already trained and skilled in the expertise being hired.

The IRS website also has a more detailed list entitled "20 Point Checklist for Independent Contractor."

Workers can file a claim that they were misclassified as an independent contractor when they believe they were actually an employee. Workers sometime do this when they file a tax return and realize they have to pay the employee and employer share of Social Security and Medicare taxes (for a total tax of 15.3%), in addition to their state and federal income taxes. Such a claim can generate a payroll audit of your company to determine if the claimant was misclassified, as well as other contract workers. This can be a time-consuming and expensive audit. Penalties may be up to 25% of the total tax due.

So, if there is any doubt in either your mind, or the worker's mind about how he/she should be classified, file Form SS-8 to request a determination of worker status under the common law rules for purposes of federal employment taxes and income tax withholding.

In coming weeks, I'll share a strategy to keep you on the straight and narrow, tax-wise, with this classification and protect your company in other ways.

And you thought taxes were boring.....