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Avoid payroll tax issues: Take care in classifying workers

The deadline to send out all W-2 and 1099s is Monday. For any small business owner, the decision to bring on an employee or use contractors is difficult and fraught with risk. A mistake in classification could mean your business owes substantial back payroll taxes and penalties.

Even though Congress has reduced IRS budgets over the last few years, the agency still closely reviews payroll tax filings. This is generally because a large percentage of tax receipts come in through wage withholdings.

The US Department of Labor investigates and refers worker misclassification cases to the IRS. Last year, the two agencies working in coordination sought back wages from employers (often small business owners) in industries as varied as construction and personnel services.

Contractors are not always cheaper

Getting an independent contractor up and running is fast with fewer administrative hurdles. As a business owner, you do not need to worry about withholding payroll or income taxes. This can reduce staffing costs when the work is seasonal or of a short duration.  

Treating the contractor like an employee, however, could become extremely costly over the long term if you are investigated by the Department of Labor or IRS. You might be on the hook for legal fees needed to defend your company. Then if you made a mistake, you could be ordered to pay back wages, back taxes and penalties.  

Worker misclassification and payroll issues are complicated areas of the law. Reviewing the common law rules related to three categories (behavioral, financial and type of relationship) is a starting place.

If your business has taken off and you have a workforce made up of employees and independent contractors doing similar work, it could be a problem. Do not wait for an investigation to kick off. If you realize that some workers have been misclassified there are ways to come into compliance.

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