When a business hires someone, that worker is either an independent contractor or an employee. Using the correct classification is crucial because federal and state governments are targeting businesses with incorrectly classified employees to collect substantial employment taxes and penalties. In addition, workers may sue for employee benefits they claim they should have been eligible for.

How do you determine the proper classification?

The IRS and the state governments have different tests. The IRS tells you to consider behavioral control (Do you have the right to control what will be done and how?), financial control (Is the worker offering their services to others and incurring their own costs?), and relationship of the parties. California boils it down to one question: Does the employer have the right to direct and control the manner and means in which the worker carries out the job? If the answer to that is not clear, there are ten secondary factors to consider including supervision, type of work, tools, payment, and relationship.

What can a business do to protect itself?

The most important thing a business can do to protect itself from a claim of improper classification is to have a written, signed contract with every independent contractor. The process of reviewing appropriate terms for this contract is as important as the writing itself. Consult an attorney for assistance in creating a contract for your company, and before making any changes to that contract. Then, follow its terms. Give independent contractors control over how they perform their duties, maintain good records such as invoices for their services, and send them a Form 1099 if you pay them more than $600 in a calendar year. Finally, treat them consistently and treat your employees differently, and be very careful when changing a workers classification—especially when you are changing it from employee to independent contractor. If you are not sure of the proper classification, you can get help from the IRS (fill out Form SS-8) or the Employment Development Department (use Form DE-38 or file form DE-1870). Be careful—a worker can also complete Form SS-8 to determine their proper classification, and if they think they have been misclassified, they can choose to only pay employee side taxes and file Form 8919, telling the IRS to go after their employer for the other half.

The recession has caused many businesses to classify more workers as independent contractors rather than employees to cut costs. However, a misclassification can end up costing the company a lot more in the end. With increased scrutiny from government agencies trying to collect taxes to help with their budgets, it is crucial to make sure your business is in compliance with all applicable laws

Tamara B. Pow JD, MBA is a founding partner of Structure Law Group, LLP.  She advises business owners and real estate investors on all aspects of business transactions, including contract negotiation, liability protection and employment issues.  She can be reached at 408-441-7500 or tpow@structurelaw.com.