Contractor or Employee?

Manufacturing companies must pay close attention to federal and state rules when determining whether someone is a contractor or employee. Unfortunately, some manufacturing company owners mistakenly believe that the misclassification of employees as independent contractors doesn’t really matter as long as contractors satisfy all their tax obligations. However, this couldn’t be further from the truth. Improper classification of workers can come at a high cost, and federal and state authorities have been cracking down on the practice in recent years. When the IRS makes a determination of whether or not someone is a contractor or employee, they examine a variety of factors that reflect the level of behavioral and financial control you have over a worker, as well as the nature of your relationship. If the IRS determines that a contractor should have been classified as an employee, it may require the manufacturer to pay back taxes, plus penalties and interest.

Advantages of independent contractor status

It’s no surprise that manufacturers prefer to treat certain workers as independent contractors. However, suppose a worker is legitimately treated as a contractor. In that case, the company avoids a variety of financial obligations associated with employees, including withholding federal income taxes, paying the employer’s share of FICA taxes (and withholding the employee’s share), and paying federal unemployment taxes (FUTA).

A manufacturer may also avoid certain obligations under state law, such as withholding state income taxes, paying state unemployment taxes, paying or withholding state disability insurance contributions, and furnishing workers’ compensation insurance. (However, some states may require businesses to provide workers’ comp to contractors or pay unemployment tax on amounts paid to contractors in certain situations.)

In addition, contractors aren’t entitled to employee benefits, minimum wages, overtime, and other rights employees enjoy.

Why it matters

There’s a common misconception that the IRS and state tax authorities don’t care about worker classification as long as they receive all their taxes. After all, independent contractors are responsible for the taxes that the employer would pay otherwise. But the government does care for several reasons:

  • First, employers are less likely to default on their tax obligations.
  • Second, it’s easier to collect taxes from a single employer than from many independent contractors.
  • Third, the government wants to maximize unemployment contributions even if all taxes are collected.
  • The U.S. Department of Labor, state labor departments, and other employment security agencies are interested in expanding the class of workers entitled to employee benefits, wage-and-hour protections, and workers’ comp coverage.

The consequences of misclassification can be harsh. For example, suppose the IRS determines that contractors should have been classified as employees. In that case, it may require the manufacturer to pay back taxes (including the employees’ share of unpaid payroll and income taxes), plus penalties and interest.

And if the manufacturer lacks the resources to pay these liabilities, the IRS can collect from “responsible persons,” including certain executives, partners, or managers. Also, remember that federal and state tax authorities can impose penalties on companies that misclassify workers even if all their contractors satisfy their tax obligations.

How to protect yourself

If your manufacturing business uses independent contractors, assess whether they constitute employees under federal and state law. In making this determination, the IRS examines various factors that reflect the level of behavioral and financial control you have over a worker and the nature of your relationship.

For example, workers are more likely to be considered contractors if they control how and when the work is done, cover their own expenses, invest in their own facilities and tools, make their services available to the relevant market, and can realize profits or incur losses. The IRS also considers the parties’ written agreements, any benefits provided to the worker, and the permanency of the relationship.

Be proactive

Given the steep price of misclassification, be proactive regarding contractor or employee status. Contact us to discuss your options if you’re concerned about potential liability.

Contact our Manufacturing Team Specialists

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DISCLAIMER: This blog is provided for informational purposes only and is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant. Presentation of the information in this article does not create nor constitute an accountant-client relationship. While we use reasonable efforts to furnish accurate and up-to-date information, the evolving landscape surrounding these topics is supported by regulations or guidance that are subject to change.

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