Status Quotient

The question of whether to classify workers as independent contractors or employees continues to haunt most small-business owners. But entrepreneurs aren't the only ones plagued by this shady issue; because of misclassifications, the IRS loses more than $38 billion in employment taxes each year.

The IRS also says that, besides the employment tax loss, many of these misclassified workers aren't paying income taxes. The agency's statistics show that when the business fails to file with the IRS, less than 30 percent of the workers report their compensation.

Businesses have good reasons for misclassifying. Because there is no clear definition between classifications, and tests distinguishing the status of each are complicated and subjective. Aside from that, organizations have a strong incentive to opt for independent-contractor classification. With independent contractors, companies need not keep track of withheld income taxes, which can be difficult in high employee-turnover industries, nor do they have to pay hefty Social Security taxes. Additionally, some workers refuse to allow anyone to report their names and compensation to the government.

Classifying may seem simple. The worker is an independent contractor if the business controls only the results of the work. The worker is an employee if the business can also control how the work is done.

The IRS' newly issued training materials gives these examples: A company asked trucker John to make a delivery from Houston to Dallas. John agrees to pick up the load the next morning. The company said the delivery must be made within two days. In this case, John is an independent contractor because the company only told him what to do. John's friend Bill, however, is an employee. He reports to the company warehouse every morning and the manager tells him what deliveries to make that day. The manager directs how to load the cargo, what route to take, and in what order to make the deliveries. The manager not only tells him what to do but how to do it.

When the distinction is not as clear, other factors are considered:

An Independent Contractor. . .

• Performs without specific instructions.

• Is paid by the job, not by the time spent doing the job.

• Can hire, supervise and pay assistants.

• Can make a profit or suffer a loss.

• Can accept jobs with other companies.

An Employee . . .

• Renders services personally.

• Must comply with instructions about when, where and how to work.

• Relies on equipment and supplies from the company, with little or no capital investment.

• Has a continuing relationship with the company and generally doesn't offer services to others.

Companies are often confused when the relationship with workers has factors on both sides. In one case, where physicians worked for a corporation, some factors supported employee status, while others supported that of an independent contractor. The IRS ruled that they were employees. In another case, dentists also worked for a corporation and the relationship possessed factors on both sides. A court ruled the dentists were independents. With mixed factors, the answer may depend on who decides the issue--the IRS or the courts.

The government has admitted that the status tests lack precision and predictability and, in many cases, yield inconsistent answers. So the tug of war between the IRS and employers continues.

Employee status triggers high Social Security taxes for the employer, not to mention the cost (and bother) of keeping records and reporting taxes withheld. This is an important consideration for small companies with high employee turnover, and also for those with a preference for concentrating on their business rather than on legal niceties. It is also important to large corporations trying to "outsource" work previously done by their own employees.

This article was originally published in the May 1997 print edition of Entrepreneur with the headline: Status Quotient.