Under competitive pressures, some employers are tempted to label workers “independent contractors” rather than employees so they can avoid paying benefits, matching Social Security and Medicare taxes, paying federal and state unemployment taxes and following employment laws, such as the Fair Labor Standards Act. This practice of misclassification has created substantial problems for affected employees and for the United States Treasury, the Social Security and Medicare funds, and state unemployment and workers’ compensation funds.
As a result, the U.S. Department of Labor and Internal Revenue Service signed a memorandum of understanding in September 2011 so the agencies could work together and share information to reduce employee misclassification, close the tax gap and improve compliance with federal labor laws. While New Mexico is not one of the 13 states that have joined the memorandum of understanding, employers in the state should be concerned about properly classifying the people who work for them.
A worker is not an “independent contractor” simply because an employer says she is. Complicated but well-defined legal tests apply to the determination, and stiff penalties can apply when employers misclassify. Among other things, an employer whose “independent contractor” is found to meet the legal definition of an employee may be required to:
- Reimburse the employee for wages that should have been paid under the FLSA, including overtime and minimum wages, and benefits afforded regular employees
- Pay back taxes and penalties
- Pay workers’ compensation benefits due an injured worker
Both New Mexico and the IRS weigh the extent to which a business controls a worker in determining whether an employer-employee or independent contractor relationship exists. The IRS “control” analysis tests three elements: behavioral control, financial control and type of relationship.
The behavioral control test looks at whether the business reserves the right to direct or control how the work is done — whether by instructions, training or other means. If a business controls not just what work is done but how it’s done, its workers are most likely employees.
The financial control test evaluates whether the business directs the financial or business aspects of the worker’s job. It measures how much unreimbursed business expenses the worker has; how much the worker has invested in his own equipment, facilities or tools used in performing services; how the business pays the worker; and the worker’s ability to realize a profit or incur a loss.
The type of relationship test focuses on how the business and worker view their relationship. The IRS evaluates written contracts that describe the relationship the parties intended to create and determines whether the business provides the worker with employee-type benefits. It considers the duration of the relationship and how key the worker’s services are to the company’s core or regular business.
When in doubt, a business can ask the IRS for a determination by filing a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, but it might consider consulting a tax or legal professional first to make sure this would be in its best interests.
For more information, visit Montgomery & Andrews website.
Download 252_Employers Who Mislabel Employees Risk Penalties PDF