Payroll Tax Issues When You Misclassify Workers as Independent Contractors

No one wants to be in trouble with the IRS.  Most of the time, you may not even be aware that a specific action could lead to a dispute.  One of the most common mistakes is confusing whether a worker is an employee or an independent contractor.  Sometimes the lines are blurred and it’s less clear than it should be.  Here’s how the IRS defines the two:

Employee – An employee is someone who works for you and you expect to continue working unless you fire them or they quit.  You control how they do their job, not just what the job is.  Importantly, you have to withhold certain expenses from their paycheck, including federal and state income taxes.

Independent Contractor – An independent contractor is someone who is completing a project for you and will not automatically continue working for you once that project is completed.  You only care about the end result of what they do for you, not how they accomplish it.  You do not withhold anything from their paycheck.

Now that you know the difference between the two, you should know why it is important.  A business owner can get in trouble for misclassifying workers.  For instance, an employee misclassified as an independent contractor could lead to an IRS investigation.  The IRS could ask you to pay back the taxes you should have been withholding from their paychecks.  Even worse, the employee could sue you for back wages.  A simple mistake could lead to financial ruin.

For further clarification, let’s look at how you can differentiate between an employee and an independent contractor.  It generally comes down to three categories of work style:

  1. Behavioral:  A company has the right to control what an employee does and how they do it, but cannot control an independent contractor’s behavior at all.
  2. Financial: A company provides an employee with the tools to do their job and reimburses any personal expenses they may have.  An independent contractor uses their own tools and funding to complete a job.
  3. Relationship: A company has a written contract (which often offers benefits) that determines how they work with an employee.  An independent contractor is not expected to continue their relationship with a company after the job is done.

That is a general guideline to discerning the difference, but sometimes it is not immediately clear.  Even more confusing, an independent contractor is defined differently in the State of Washington than it is by the IRS.  To be classified as an independent contractor for the State of Washington, an individual may even have to have their own business license.  Washington State employers have to follow the IRS definition for withholding federal income tax and the state’s definition for withholding state taxes. 

If learning all of this is concerning to you, we’re here to help.  We help individuals and small businesses resolve their disputes with the IRS.  If you are worried about a misclassification issue, reach out to us today to set up a free initial consultation with our team.

Latest posts by Robert V. Boeshaar (see all)