Many startups and small businesses get themselves into serious trouble by classifying their workers as independent contractors instead of employees. Employees are more expensive in terms of taxes and administration, so it is tempting to classify all workers as independent contractors. But the penalties for misclassification can be severe.

A business that misclassifies workers can be hit with both state and federal penalties. The federal penalties can include a trust-fund penalty that is equal to 100% of the unpaid tax. The trust-fund penalty sticks to the business owners, regardless of entity type, and can’t be shed in bankruptcy. Penalties like this can easily stop a startup and destroy a small business, not to mention bogging you down personally for years to come. As the IRS has recently begun ramping up its misclassification inspections—because the government knows it’s leaving lots of money on the table—it is more important than ever to know for certain who is and who is not an employee, and to get that classification squared away with your worker and with the government.

As a brief overview, workers come in two flavors: independent contractors and employees. Independent contractors are really just small-business owners. When you hire an independent contractor, you are outsourcing work to another small business. Frequently that small business is just a sole proprietor with no separately established entity or business name. (Which, as I previously discussed, is a bad idea on the contractor’s part.) As with payments to any other business that you patronize, it is not your responsibility to withhold or pay taxes on behalf of an independent contractor. You simply send the contractor and the IRS an informational 1099 return showing the amount that you paid, and the contractor handles the rest.

(The contractor should handle the rest. Frequently misclassified workers assume that their employer withheld and paid tax on their behalf. When the IRS gets a 1099 and no corresponding taxes from the contractor, an investigation begins that often ends up with the employer being held liable for misclassification. The other big way that companies get caught misclassifying is when contractors are laid off and go to apply for unemployment that was never paid for.)

Employees are different. Employees are your internal staff. You have substantial control over the schedules, projects, and performance of your employees. And you are responsible for withholding taxes that your employees owe, and for paying additional employment taxes such as unemployment tax and matching contributions to FICA.

The IRS distinguishes between employees and independent contractors by looking at the 20 factors established in Revenue Ruling 87-41. Some of the most significant factors are:

• The amount of instruction that you give to your workers (contractors only get very general instructions such as “install an 8’ x 10’ patio” or “prepare our year-end tax returns”; employees get detailed direction)
• Whether or not you provide training (employees get trained, contractors don’t)
• Whether the services you pay for must be provided by the worker, or if they can be further outsourced
• The duration of your relationship (longer indicates employee)
• Whether you set working hours (contractors tend to work whenever they like)
• Whether work is done on your property (tends to indicate an employee)
• Whether workers provide their own tools and equipment (contractors bring their own gear)
• Whether the worker can quit or be fired at any time (employees can be fired; contractors have a contract)

These factors are not exhaustive. And there are exceptions to every one. But they all get at what the IRS is really looking for: control. If you control the worker, she is an employee. If you simply pay for a job and let the worker figure out the details, she is probably and independent contractor.

For example, if you hire someone to pave your company parking lot, paint your office, or do your taxes, that person is probably an independent contractor.

But if you hire someone to answer your phones every day from nine to five, that’s an employee. If you hire someone to sit in your office and bang out code to spec, that’s an employee. And if you hire a worker to supervise a team out in the field, that person is in all likelihood an employee.

If you’re in a situation where you think you’ve been misclassifying employees as independent contractors, all is not lost. In order to increase compliance with the classification rules, the IRS has implemented a Voluntary Classification Settlement Program.

As the title suggests, the Voluntary Classification Settlement Program allows businesses to voluntarily re-classify their misclassified workers. In exchange, the IRS agrees to forego all taxes that could have been levied against the business, except for 10% of the liability from the most recent tax year. The IRS also agrees not to impose any penalties or interest, and it won’t audit your employment taxes for prior years.

In other words, under the Voluntary Classification Settlement Program, your business pays just 10% of the tax it should have paid last year, and agrees to pay the proper tax in the future. In exchange, the IRS agrees to leave you alone.

If you suspect that you have been misclassifying workers, check out the IRS link above, sit down with your accountant, give me a call, and give some serious thought to taking advantage of this offer before it is too late.