The decision about whether to hire independent contractors or employees can pose complex and at times perplexing issues. A number of different but interrelated factors bear on the question. While the promise of avoided payroll taxes, workers compensation and health benefit premiums may entice an employer to favor the independent contractor characterization, significant risks attend that determination. So the threshold inquiry of whether the contemplated hire would even qualify as an employee is crucial.
In every state, employers who are under an obligation to purchase workers compensation insurance but do not, are exposed to significant penalties. Depending upon the jurisdiction, such penalties could include fines and possible jail time. Often a corporation's executive officers are held personally liable for such penalties. Also, employers who fail to maintain the required workers compensation insurance may be prohibited from conducting business so long as they are not in compliance with the law. Finally, in the event of a claim, the delinquent employer may be precluded from raising any liability defenses. The only question at trial, will be the amount of damages.
From a tax perspective the consequences of having an independent contractor reclassified as an employee are significant as well. The employer may be held responsible for both the employers and employees FICA and FUTA, as well as perhaps the federal income tax on the gross wages paid out to the employee in question. The IRS may also bring in the state and as a result, the employer could also become liable for the state income tax, as well as state unemployment and worker's compensation. Employer's may also face a penalty equal to the amount of the back taxes owed. Likewise, the employer will owe interest on all back taxes from the due dates. And, the business may be required to support the injured person for the rest of their life.
In all jurisdictions, most employees fall within the scope of workers compensation regulation. Business owners, officers and directors may elect whether or not to be covered. Some business owners view workers compensation insurance as inexpensive disability coverage for themselves. However, if they do elect coverage, their benefits are normally restricted to an amount based on an imputed salary level, even if their actual compensation is much higher. Also, if they suffer a disability which is not work related, no coverage would apply.
Several states exempt from regulation employers with fewer than a specified number of employees or annual payroll below a given amount. However, even in these states construction industry employers are subject to workers compensation laws even if they have one employee.
Whether a particular worker is an employee or an independent contractor is central to whether workers compensation laws apply or not. Even so, many state laws provide little guidance to aid in determining whether a particular worker should be categorized as an employee or as an independent contractor. Many state laws are completely silent on this question. A number of statutes simply state that independent contractors are not employees within the meaning of the statute. A few states have specifically spelled out criteria for determining a particular employee's status as an independent contractor or employee. Where the workers compensation statute is silent, normally an employer will have to rely on common law principals to determine the worker's status.
As noted, the employee's classification can also have significant tax consequences. The IRS generally uses the following criteria for making such determinations: