In the construction industry, classifying workers as employees or independent contractors must be done correctly, or business owners risk penalties imposed by the Internal Revenue Service (IRS) and the Department of Labor. In addition, contractors working on government projects must take extra care to classify workers correctly when submitting certified payroll reports.
According to the Coalition for Independent Contractor Freedom, the construction industry has one of the highest rates of self-employed workers. More than two million people, or 20 percent of industry workers, are labeled independent contractors.
Worker classification differences are significant. Employees get a paycheck with certain taxes deducted and are issued a Form W-2 at the end of the year by the employer; independent contractors get checks with no taxes deducted, and are issued a Form 1099 from the employer that states how much they were paid for the year. Classifying workers as independent contractors may save employers money because businesses don’t incur payroll taxes—such as Social Security and unemployment insurance—for the individual, and are not required to provide the individual with employee benefits or workers’ compensation insurance.
Though it’s tempting to save on labor costs, employers that incorrectly classify workers as independent contractors face serious IRS penalties.
Who’s in Control?
Several federal laws offer guidance on determining whether an individual is an employee or an independent contractor. Workers may qualify as an independent contractor for tax purposes, but not for other purposes (i.e., wage and hour). However, the IRS specifically looks at the extent the business has the right to direct and control the worker with regard to the job’s description and how it should be completed. Construction managers generally have the right to control how employees perform their work, but independent contractors can determine for themselves how the work should be performed.
In deciding worker classification cases, the IRS examines evidence in three main categories: behavioral control, financial control and the relationship of the parties.
Behavioral control factors include any instructions the employer gives the worker about when, where and how to work, and any training the worker receives. Independent contractors ordinarily control their own work schedules and any necessary education or training.
Financial control generally refers to the ability to realize a profit or loss. This might include the extent of unreimbursed business expenses the worker incurs. It also takes into account how much the worker invests in facilities or equipment.
The relationship between employers and workers can reflect the intent of the parties. Factors could include whether a written contract is in place, or whether the business provides the worker with employee benefits such as insurance, paid time off or a retirement plan.
Crime and Punishment
The liability for an employer that unintentionally misclassifies an employee is limited to 1.5 percent of the employee’s wages for income tax withholding and 20 percent of the employee’s portion of FICA tax. However, intentional misclassification of a worker exposes the employer to more severe repercussions. The range of disciplinary actions can include the full amount of income tax that should have been withheld; the full amount of the employer’s and employee’s FICA payments, interest and penalty amounts; and possible civil and criminal penalties, including jail time for the worst offenders.
Employers should not feel secure in classifying a worker as an independent contractor simply because the worker:
- wants to be treated as an independent contractor;
- signs a contract;
- performs assignments sporadically, inconsistently or is on call;
- is paid commission only; or
- performs assignments for more than one company.
When in doubt, it usually is wisest to classify a worker as an employee. If a worker is classified as an independent contractor, the hiring firm has the burden of proving it had no control over the work or the worker. Employers may seek guidance from their legal counsel or CPA when classifying employees. The IRS also offers employers the opportunity to obtain a definitive ruling regarding a worker’s status by completing Form SS-8 (available at
www.irs.gov/pub/irs-pdf/fss8.pdf).
Employers should be aware that other government agencies may find reason to look at an employee’s classification. For example, when a former worker files an unemployment insurance claim, an investigation automatically is triggered to determine the worker’s status.
Safe HarborsEmployers may qualify for relief under Section 530 of the IRS Code when found to have misclassified a worker. To meet the requirements for this safe harbor, an employer must show a reasonable basis for its decision, which might include relying on:
- a judicial precedent, published rulings, technical advice with respect to the taxpayer, or an IRS letter ruling to the taxpayer;
- past IRS audits—applicable only if no penalty related to the treatment of individuals holding similar positions in the business was assessed; or
- longstanding, recognized practice of a significant portion of the industry.
An employer also must show substantive consistency when classifying workers and independent contractors who perform the same tasks, and when filing the appropriate tax forms.
Certified Payroll for Government Contracts
The Davis-Bacon Act requires covered contractors and subcontractors to maintain payrolls and basic records and to submit certified weekly payroll reports for continued compliance.
Many government contractors are subject to the Davis-Bacon Act, including an increasing number of construction firms as a result of the American Recovery and Reinvestment Act of 2009.
Outsourcing payroll and reporting tasks is an option for business owners that need to correctly classify workers and accurately report on government projects. In addition to saving businesses time and preventing penalties, outsourcing:
- automatically creates reports from weekly payroll data;
- captures all employer, employee and job information;
- provides a “no work” report following a temporary break in work;
- includes reports that list fringe benefits paid in cash; and
- stores data in a database so reports can be reprinted at any time.