Life Sciences Articles
Walking the Fine Line between "Employee" and "Independent Contractor"
By C. Joseph Ciccarello, CPA/MST
Gray, Gray & Gray
At what point does an independent contractor become an employee? And why will the wrong classification cost many biotech businesses a lot of money?
For many years, the Internal Revenue Service has stepped up enforcement of its definition of "employee" vs. "independent contractor." This could mean trouble for your business. Misclassified workers can cost you in the form of penalties, interest and back taxes.
According to author James Bovard, writing in Insight magazine, the IRS is "waging a campaign to slash the number of self-employed Americans and punish the companies that pay them for their work." This scrutiny of employment status has affected all types of companies and individuals, from high tech and health care to the movie industry and the clergy.
This crackdown by the IRS has meant a surge in the number of employment audits being conducted. As a result, businesses of all sizes are rushing to examine their relationships with independent contractors.
Using an independent contractor to supplement a company's workforce has long been a common practice. This method of adding manpower without adding permanently to staff comes under many guises and names - outsourcing, consultants, temporary help, freelancers, seasonal workers. Aside from the obvious attractions of payment-for-performance and zero benefit costs, there are additional financial advantages to using independent contractors. Payroll and social security taxes become somebody else's headache.
Quite often, these independent contractors act as part of a company's workforce, utilizing laboratory or office space, materials and resources as if they were employees which the IRS may view as fact.
The focus by the IRS on abuses of the independent contractor system makes it more important than ever to make sure you are properly classifying individuals working for or with you, especially scientists and clinical researchers. Treating workers as independent contractors for payroll tax purposes is not enough to prove their independent status. Even having the worker sign off on a statement that they are an independent contractor is not binding.
The IRS uses a checklist of twenty criteria to determine if an individual is an independent contractor or an employee. Many of the "tests" used by the IRS to determine employment status come from common law precedents that date back to the Magna Carta, and were used to regulate the relationship between a master and his servants.
The primary basis of the definition is control - control of the method of work, what is worked on and the criteria under which the work is performed. If control belongs to the employer, the worker is likely to be classified as an employee. The opportunity for gain and risk of loss is also an important part of the definition.
Compare your relationships with independent contractors against this list of twenty cumulative IRS factors:
- Directions. Do you issue directives on how work is to be performed?
- Training. If you provide training, you are exhibiting a degree of control over how work will be performed.
- Integration. If independently contracted services become integrated into your company's operations you could have a new employee.
- Personal Service. An employee is required to do work personally. An independent contractor has no such requirement.
- Assistance. If you hire assistants for an independent contractor, you are essentially integrating the work into your company. The contractor has become an employee.
- Continuity. An ongoing working relationship generally indicates employment.
- Hours. If you set working hours, you have taken away some of the "independence" of your independent contractor. You may be considered an employer.
- Full-time Status. If you dominate a contractor's time, so as to prevent other contracts, this may be construed as employment.
- Location of Work. If an outside contractor must perform work at or through your laboratory, offices or facility, an employment situation may exist.
- Sequential Requirements. If you set a specific order or sequence for work to be performed, undue control is being forced on the independent contractor - control usually reserved for employees.
- Reporting. Requiring regular reports (either written or oral) is an indication of employer/employee status.
- Payment. Payment on an hourly, weekly or monthly basis may indicate an employment relationship. Independent contractors are usually paid in a lump sum or on straight commission.
- Expenses. If you pay business or traveling expenses, you are indicating employment status for that worker.
- Supplies. If you furnish supplies or tools required for the job, employment is indicated.
- Investment. Your employees usually do not have a significant investment in the property where they are employed or in the equipment they use. Independence may be defined by proving such investments.
- Profit and Loss. An independent contractor has an opportunity to realize a profit (or loss) on his or her work. An employee is generally limited to a salary or hourly wage.
- Multiple Contracts. A worker who performs for only one company at a time is considered an employee. An independent contractor can (and should) be working for more than one company.
- Promotion. Employees have no need to advertise or promote their services. Therefore, any promotion would indicate an independent status.
- Right to fire. A key factor. An independent contractor cannot be dismissed as long as contract terms are being met. Most employees can be fired at will.
- Right to quit. A non-contract employee can walk out at any time, while an independent contractor is legally bound to complete the work specified in his or her contract.
In Massachusetts, an IRS employment audit can be just the beginning of an employer's troubles. Once the IRS finishes with you, the state may get involved for back taxes, workers' compensation and labor law violations. Under the wage laws in Massachusetts, all workers are presumed to be employees. It is up to the employer to prove that the work was performed by an independent contractor - not an employee.
In summary, to prove a worker is an independent contractor, an employer must show that the worker was free of the employer's control and direction; the work was performed outside the usual course of business or outside of all places of the employer's business; and that the worker is customarily engaged in providing such independent services while receiving no employee benefits.
There are still advantages to hiring independent contractors to carry some of your company's workload, such as supplementing your existing workforce when required, being able to pay as the work is performed and less need for human resource administration. But you must proceed with caution, and be especially careful in establishing their work processes and activities. Know and observe the new rules defining the difference between employee and independent contractor, or you may find yourself with several new employees - and a mountain of legal and financial trouble.
Joseph Ciccarello, CPA is a partner with Gray, Gray & Gray, LLP, Certified Public Accountants, Westwood, MA. Gray, Gray & Gray serves the tax and accounting needs of businesses in the life sciences industry. Mr. Ciccarello can be reached at (781) 407-0300, or via e-mail to: jciccarello@gggcpas.com.