With the recent increase in the number of federal and state task forces aimed at curbing tax fraud in the construction industry, construction companies would be wise to ensure their businesses are in compliance with the tax laws. One area in particular that has drawn increased scrutiny by federal and state tax authorities is the misclassification of construction workers as independent contractors instead of as employees of the business. Construction companies can reduce the risk of an audit and incurring costly penalties by accurately classifying its workers at the outset of the relationship. 

Why worker classification matters

It is important to understand the difference between an employee and an independent contractor because the worker’s classification determines whether the business must withhold income taxes and pay Social Security, Medicare taxes and unemployment tax on wages paid. Generally, businesses are required to withhold and pay taxes on wages paid to employees but do not normally have to withhold or pay taxes on payments made to independent contractors.

While using independent contractors instead of employees on a job can lower labor costs by 20% to 40%, construction companies should recognize that deliberately misclassifying workers as independent contractors can result in hefty penalties and the assessment of additional taxes and interest if the business is audited by the government. These penalties, taxes and interest can total many millions of dollars depending on how many workers are misclassified.

Determining whether a worker is an employee or an independent contractor

Determining whether to classify a worker as an employee or independent contractor is based primarily on the degree of control the employer exercises over the worker. Workers are generally considered employees when they perform duties dictated or controlled by the employer. Workers are generally considered independent contractors when the workers are free to control the details of how they perform and complete the work.

The three factors considered by the Internal Revenue Service (IRS) to determine the classification of a worker are:

• Behavior control;
• Financial control; and
• The relationship of the parties.

Behavior control looks at the extent to which the business has the right control how the worker does the task for which the worker was hired. Some factors to consider include the instructions that the business gives the worker about when and where to work, what tools or equipment to use, where to purchase supplies, what order or sequence to follow when performing the work, and whether training was provided to the worker on how to perform the work.

Financial control looks at the extent to which the business controls the financial aspects of the worker’s job. Some factors to consider include whether the worker has invested in his own tools, the extent to which the worker’s expenses are reimbursed by the business, the extent to which the worker makes his services available to the public and how the business pays the worker. For example, an independent contractor likely gets paid a flat fee or on a time-and-material basis, while an employee usually gets paid a regular wage.

The type of relationship between the business and the worker considers whether there is a contact in place, whether benefits are provided, and the permanency of the relationship between the worker and the business.

Employers must weigh all of these factors when making a determination about whether a worker is an employee or an independent contractor. No one factor is determinative, and the key is to evaluate the entire relationship between the worker and the business. A more detailed description of all of the facts and circumstances considered by the IRS, as well as several construction industry-related examples, can be found in IRS Publication 15-A.

It also is important to note that state governments take worker misclassification very seriously. With some states reporting a 150% increase in the number of workers being misclassified, state government enforcement has been increasing as well. Independent contractor laws vary by jurisdiction and construction companies should consider any local laws.

Best practices for worker classification

Ensure human resource managers know the rules. Develop checklists or other forms that list the requirements for classifying new workers to ensure and document that workers are classified appropriately. These forms should be maintained for at least six years in the event there is a government audit. Internal audits also should be routinely conducted of all workers to determine if a worker’s classification needs to be reassessed given the evolving nature of job responsibilities.

If classifying a worker as an independent contractor is appropriate under the rules, then another best practice is to enter into a contract with the independent contractor to document the nature and duration of the relationship. Businesses should take care when classifying a worker as an independent contractor if the relationship is going to be long-term or last indefinitely. The longer the worker is with a business, the more the worker starts to look like an employee.

Proceed with caution when using so-called “labor brokers” to obtain workers for a construction project. While labor brokers may quickly be able to locate the manpower needed for a project, the workers may be deemed by the government to be employees of the construction business—not the broker. For example, last year, the Attorney General for the District of Columbia sued an electrical contractor for allegedly misclassifying more than 500 workers through the use of two labor brokers.

True independent contractors should have their own insurance, their own business location, a business license and a customer list that indicates their services are offered to the public. Independent contractors should be paid through accounts payable, while employees should be paid out of the business’s payroll account.

As federal and state tax authorities continue to pursue construction businesses for misclassifying employees, it is imperative that businesses focus their attention on ensuring compliance and classifying workers correctly. Paying careful attention to how employees are classified and paid, as well as keeping good records, is a sure way to reduce the risk of costly penalties, taxes and interest.