Worker Classification: A Rose by Any Other Name Would Smell as Sweet
Companies that hire independent contractors are not obligated to withhold income taxes or employment taxes (such as Social Security and Medicare) or pay the employer share of employment taxes and unemployment insurance. But, just because an employer labels its workers “independent contractors,” as opposed to “employees,” doesn’t make it so.
For both federal and Minnesota tax purposes, worker classification inquiries go well beyond the label. Classification depends on a complicated, fact-intensive analysis, often interpreted by revenue agencies in favor of an employer-employee relationship. The analysis focuses on the relationship between the company and the worker, particularly, the level of control the company can exert over workers.
Because both the Internal Revenue Code and Minnesota’s definitions of “employee” are circular, see Treas. Reg. § 31.3401(c)-1(a) and Minn. Stat. § 290.92, subd. 1(3), the corresponding revenue agencies rely on common law definitions of “employee.” Over time, these definitions have been categorized into three groups: behavioral control, financial control, and relationship.
This category considers whether the company has the right to control the manner and means in which a worker performs services. The focus is on whether the company can exert control over how a service is performed, not simply on the final product. For example, can the company require the worker to use certain tools or to follow a specified method? Or, is the worker highly skilled and exercises his or her own expertise in executing the contract, so as to just deliver an agreed outcome or result?
This category considers certain financial aspects of a worker’s job. For example, is the worker able to negotiate the contract fee, does the company provide materials and other equipment, or can the worker offer her services to competitors and/or the public? Financial control also contemplates whether the worker has any financial risk in taking on the contract and whether he or she has the ability to make a profit or recognize a loss.
The final category depends on how the company and worker perceive their relationship. For example, if there is a written contract, what does it say? (Keeping in mind that simply labeling a worker an independent contractor is not enough proof that the worker actually is one in the eyes of taxing authorities.) Does the worker receive typical employee benefits, such as insurance or a sick pay? How permanent is the relationship—i.e., does the relationship last for a specified period or indefinitely?
No one factor is determinative and certain factors may weigh more heavily, especially in certain industries. Interestingly, because the consequences of misclassifying an employee can be so debilitating, including the tax liability, penalties, and interest, Congress established a relief program. Referred to as Section 530 Relief, the program provides certain relief to noncompliant employers. However, as with the classification analysis, eligibility under Section 530 is likewise complex. Though Minnesota does not officially offer a similar program, it will sometimes consider whether similar relief is appropriate.
In short, if you are an employer, or you represent employers, be aware of the following:
- simply because a contract says a worker is an “independent contractor” does not mean that they are one, and
- worker classification audits are increasing in frequency.
In this case, a rose by another name certainly smells sweet to taxing authorities.