Can PEOs Protect Against Misclassified Independent Contractors?
There are many questions surrounding Independent Contractors these days. Do services rendered by an individual for your company constitute an act of employment, or are they truly services being provided by an independent party? What types of occupations are clearly recognized as independent contractors in the eyes of the Internal Revenue Service? How can I protect my business when paying independent contractors? What are my risks for misclassification?
IRS enforcement actions against small and midsize corporations for misclassifying employees are on the rise, and the penalty for non-compliance can be substantial. Employers who have misclassified workers are responsible for the payment of all back taxes. This includes not only the employers 7.65% share of federal taxes for Medicare and Social Security, but a portion of the employee’s share of FICA as well. Now add state and local unemployment taxes then compound for 3 or 4 years. When your finished, multiply this figure by 5 or 10 employees and it’s easy to see why so many business executives are concerned when confronting this issue. With the stakes so high, many companies are seeking ways to eliminate this exposure.
Professional Employer Organizations and Independent Contactors
There are several strategies that employers are using to insulate themselves from exposure to the IRS. Some business owners and HR executives have turned to outsourcing the payroll and administration of their independent contractors to administrative employers, employee leasing companies, professional employer organizations, and staffing companies.
The mere fact that a third party handles a company’s payroll administration does not absolve them from their obligation for collecting and paying employment taxes. The decision whether an individual performing a service on behalf of your company is an employee usually comes down to control. Who controls whom, how, where, when and what work is performed. While it is only one of several factors considered by the Internal Revenue, in most cases it is the determining factor.
Engaging the services of a professional employer organization is a matter of contract law. Most of the contracts from the country’s leading PEOs have language in their co-employer agreements which specifically exclude independent contractors. Some PEO’s and many employee leasing companies will provide payroll and administrative services for companies who employ independent contractors, however they are not the employer.
Most co-employment agreements spell out the terms of shared responsibility for employment related functions between the PEO and client company, and assigns responsibilities for each party to the contract. The PEO acts the administrative employer of record. The client or co-employer is the work site employer who assigns where each employee reports, hours they work, and job function. Payroll, employee leasing companies, or professional employers cannot protect employers if audited by the IRS for misclassified employees, the burden of proof and liability is with the business and the employer.
IRS Guidelines for Hiring Independent Contractors
Facts that provide evidence of the degree of control and independence fall into three categories:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another. The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.
Don’t Guess – Ask the IRS
If an employer or employee is unsure, either party can submit Form SS-8 to the IRS. They will make a final determination and notify you of the worker’s status.
Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding
Be aware that it can take at least six months to get a determination, but a business that continually hires the same types of workers to perform particular services may want to consider filing the form.
Contact us for additional information on independent contractors and HR outsourcing.