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Classifying workers properly

Contractors are distinguished from employees by means of an IRS test used to determine worker status. It's important to understand how this determination is made, as the risks of misclassification are significant.

The IRS test is fairly subjective, and can be influenced by what's common practice in your industry. It examines three key areas.

• Behavioral control, or the degree of control the employer exercises over the manner in which the job is performed,
• Financial control, or the extent of financial responsibility and risk assumed by the worker, and
• The relationship, or the understanding and agreement between parties.

To decide whether a worker is a contractor or an employee, the IRS will ask whether a worker is economically dependent on the business for continued work. The greater the dependence, the more likely he's an employee. A worker will almost always be classified as an employee if the company has the right to determine when, where, or how the work is done. If instead the worker bears considerable financial responsibility, has control over the manner and means of work, and is operating under a written contractor agreement, she'll more likely be classified as a contractor.

The IRS is aggressive about identifying misclassified contractors, and the back taxes and penalties for an incorrect classification can be steep. You may be subject to an audit if someone you hired as a contractor later files for unemployment or worker's compensation. If the agency doesn't have a record of this person as your employee, they're likely to start an investigation.

In short, understand the basic rules, be cautious when hiring, and seek help when you're unsure.