Employee or independent contractor? - Why you should know the difference

In the construction industry, confusion over the classification of workers is a common occurrence. Although common, this issue is not one to take lightly. Improperly classifying workers cannot only lead to unnecessary headaches, but also hefty penalties. Therefore, it is extremely important that businesses correctly determine whether the individuals providing services for them are employees or independent contractors. The NY State Department of Labor (NYSDOL) provides strict definitions regarding the classification of employees as well as the penalties for those who misclassify by way of The New York State Construction Industry Fair Play Act. The law presumes that any person performing services for a contractor shall be classified as an employee, unless the person is a separate business entity as defined under the Separate Business Entity Test, in which case the person will be considered an independent contractor. According to the NYSDOL, you are an employee unless you are: * Free from control and direction in performing the job, both under contract and in fact; * Performing services outside of the usual course of business for the company; and * Engaged in an independently established trade, occupation, or business that is similar to the service they perform. If the worker in question does not meet this criteria, and qualifies as an employee, certain considerations must be made. Income taxes generally must be withheld, social security and Medicare taxes must be withheld and unemployment tax on wages paid to an employee must be paid. If the aforementioned criteria does apply, then the worker in question could qualify as a legitimate independent contractor, which means you do not have to withhold or pay taxes on payments to them. To determine this, you can apply the "Separate Business Entity Test." Under this test, to be considered a separate business entity, the service provider must meet all of the following criteria: 1. Be performing the service free from the direction or control over the means and manner of providing the service, subject only to the right of the contractor to specify the desired result; 2. Not be subject to cancellation when its work with the contractor ends; 3. Have a substantial investment of capital in the entity, beyond ordinary tools and equipment and a personal vehicle; 4. Own the capital goods, gain the profits, and bear the losses of the entity; 5. Make its services available to the general public or business community on a regular basis; 6. Include the services provided on a federal income tax schedule as an independent business; 7. Perform the services under the entity's name; 8. Obtain, and pay for, any required license or permit in the entity's name; 9. Furnish the tools and equipment necessary to provide the service; 10. If necessary, hire its own employees without contractor approval, pay the employees without reimbursement from the contractor, and report the employees' income to the Internal Revenue Service; 11. Have the right to perform similar services for others on whatever basis and whenever it chooses; and 12. The contractor does not represent the entity, or the employees of the entity, as its own employees to its customers. Another way of understanding the business relationship that exists is to refer to Common Law rules, in which three areas are considered. These areas provide guidance as to the degree of control and independence that exists. Considerations include: 1) Behavioral a) Who has control over what the worker does and how he does his work? i) If you do, worker is an employee. ii) If much of how the worker works and what work he decides to do is up the worker, he is operating more so as an independent contractor. 2) Financial a) Does payer control pay rate, reimbursements and tools? i) If so, worker is an employee ii) If not, worker is an independent contractor 3) Type of Relationship a) Are there written contracts or benefits for pensions or benefits? i) If so, worker is an employee ii) If not, worker is an independent contractor Often these situations are not as cut and dry as they seem. Especially in the construction industry, the misclassification of employees runs rampant, and the consequences of incorrectly treating an employee as an independent contractor are significant. If you incorrectly classify an employee as an independent contractor and you have no reasonable basis you may be held liable for employment taxes. Sec. 6672(a) of the Internal Revenue Code provides that "any person required to collect, truthfully account for, and pay over any tax imposed who willfully fails to do so, will, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of tax, not correctly collected and paid over" the term. The use of the term "any person" is important because Sec. 6672(a) allows the IRS to pierce the corporate veil and proceed against anyone who is responsible for the corporations failure to pay over withheld payroll (also known as trust fund) taxes, thereby making that person personally liable for the employers unpaid payroll taxes. This is called the trust fund recovery penalty. While certain criteria have to be met in order for the trust fund penalty to be applied, it is important to know that the IRS is aggressive in assessing this penalty. The failure to pay trust fund taxes can lead to criminal charges. Under Sec 7202, a willful failure to pay over or collect tax is a felony punishable by up to $10,000 in fines or five years in prison. In some cases, both penalties are applied. Joseph Molloy, CPA is the director of construction taxation, Grassi & Company CPAs P.C., Jericho, N.Y.