By:  S. Eric Bass, J.D., M.B.A.

You may be able to relate to my client, Joe Fitnessbuff.  Joe owns and operates a small local gym that also provides individual personal training services.  Like many small business owners, Joe is always looking for smart ways to cut costs.  He has found that making payroll and providing benefits for his workers are some of his most expensive obligations.  In completing his payroll, he must withhold the employee’s portion of FICA taxes, pay a matching FICA tax as the employer, pay unemployment taxes, withhold income taxes (state and Federal), and furnish employees with W-2 forms each year.   These items are in addition to any benefits he may provide or other optional withholdings made for employees.  Joe also pays a fee to another company to administer his payroll for him.

Joe has heard from some friends and business advisors that he should treat his workers as “independent contractors” instead of “employees.”  In doing so, they claim he can simply pay the workers the agreed hourly rate and have no other out-of-pocket taxes or expenses for payroll.  The taxes paid on the workers’ incomes are then the responsibility of each worker, not Joe’s business.  To Joe, this sounds great!  He is seriously considering this option.  However, according to the IRS and our court systems, the decision is not entirely up to him-the business owner.

Why Does it Matter What You Call Them?

Joe and all other business owners should know that, in determining payroll tax and certain other obligations, the IRS and other government agencies won’t just take his word for it that his workers are independent contractors.  Even if he and the workers agree, the IRS will not simply rely on those agreements.  The IRS will make the determination for itself, which could result in back taxes and significant penalties for Joe if the IRS determines that his workers are actually employees.  For example, the penalties for failure to withhold and pay FICA and unemployment taxes range from 20% to 40% of the unpaid amounts plus interest.  He may also be responsible for additional amounts if the workers do not pay their share of the FICA taxes.  Thus, it is vital that Joe know how the IRS will determine whether his workers are employees or independent contractors.

What Is a Contractor? What is an Employee?

Unfortunately, there is no simple yes or no test that will tell Joe whether he can treat his workers as independent contractors.  The decision depends on each situation and how it relates to certain factors considered by the IRS.  Most importantly, if Joe has the right to control and direct the workers as to the details and means by which they accomplish their duties for him, they are considered employees.  It doesn’t even matter whether he actually does control the workers, only that he has the authority to do so.  Many other factors are considered as well.  While the factors are too many and too detailed to give a comprehensive list here, some of the major factors are:

  • the amount of instructions given to workers
  • the training provided to workers
  • how integral the workers are to Joe’s business operations
  • whether his workers hire and supervise their own assistants
  • the workers’ authority to set their own hours of work
  • whether the working relationship is continuing or not
  • whether the workers must perform services on Joe’s premises
  • how the workers are paid
  • whether the workers furnish their own tools and equipment
  • whether the workers perform services for others
  • the ability to terminate the relationship without a penalty

How to Make the Decision

Joe must examine the current situation with his trainers according to many factors and make a determination as to whether the IRS will deem them employees or independent contractors.  If he believes they can be treated as independent contractors already, then he can move forward with his plan.  If not, he may consider whether it is possible to modify their “jobs” such that they may become independent contractors.  However, if the jobs cannot be modified sufficiently, Joe must treat them as employees.

As always, there is much more involved in the decision whether to treat workers as employees or independent contractors than we can include in this article.  Joe and other business owners facing this dilemma should generally seek the counsel of an attorney to help them make the correct determination.  While conducting this exercise, Joe may also want to work with his attorney to prepare written employment or independent contractor agreements with his workers.  These agreements can help describe the relationship properly and deal with other important issues, such as non-competition restrictions and confidentiality of information.  Such assistance can help greatly reduce the risks of costly charges for unpaid taxes and associated penalties.   Joe, just like other business owners, can then be more confident of his decision and focus on other productive ways to increase his profitability.            For more information, reach out to Venn Law Group today.