The Internal Revenue Service (IRS) and the U.S. Department of Labor will be cracking down on employers who pay workers without withholding and remitting proper employer payroll taxes. In fact, over the past year, many states have signed on with the feds to exchange information. This means if you are audited and found delinquent in your federal employment taxes, you will almost certainly be audited by the state you operate in and have to pay them as well or vice versa.

So, how do you determine if a worker is an employee or an independent contractor? First, understand the reporting and tax responsibilities of an independent contractor relationship versus an employer/employee relationship.

Under an independent contractor arrangement, the employer must have the contractor complete a W-9. This form is used to request the correct name and Taxpayer Identification Number of a worker. You must retain the W-9 for at least four years. If you paid an independent contractor $600 or more for services provided during the year, you must complete and file a 1099-MISC and provide a copy of the 1099-MISC to the independent contractor the year following payment.

Under an employer/employee relationship, employers generally must withhold federal income tax as well as Social Security and Medicare taxes from their employees’ wages. You also must report and pay the employer portion of Social Security, Medicare and Federal Unemployment Tax, as well as other state tax and withholdings. As for reporting and paying employer payroll taxes and employee withholdings, there are several quarterly and annual filings you need to prepare.

Based on the reporting and tax payment rules above, why would anyone classify a payee as an employee? After all, the reporting and tax rules associated with an independent contractor are minimal, and on the employer side, the employer taxes associated with an employee could cost as much $1.15 or more for every dollar paid to an employee.

It’s important to note the differences between contractors and employees.

The general rule is an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.

There are several criteria that can be applied to determine the difference between an employee and an independent contractor, but essentially:

• Do you control what the worker does and how it gets done, such as the time and place the work gets done?
• Do you control the financial aspects of the relationship, meaning hourly rate, if there are benefits, how expenses are reimbursed, etc.?
• Do you control the continuation of the project past just a certain aspect?

If “yes” to the previous questions, you have an employee and not an independent contractor.

The IRS will decide, if you like, for either the payer or the payee by filing form SS-8. It may take up to six months after filing to receive a response, so filing an SS-8 only makes sense if an employer is continually hiring the same types of workers to perform the same types of work. Note: A payee can request a determination without the payer’s knowledge. If the determination comes back that the payee is actually an employee when being paid by the payer as an independent contractor, the prospect of an audit may be in the future for the payer.

So, what’s the potential cost of misclassifying an employee as an independent contractor? First are the federal and state tax liabilities that should have been paid if the worker were properly classified. Second are a series of civil and criminal penalties as well as interest that could potentially accrue. These penalties include failure to file and deposit taxes, accuracy and willful neglect of tax payments due, among others. The penalties and interest relating to misclassification could be several times the actual taxes themselves, and there may be criminal sanctions. While the above penalties and interest are an extreme case, the monies due can be significant. The IRS and states may have several voluntary programs where a prior violator of proper classification can report properly, and, in many cases, penalties may be reduced. If, as an employer, you have misclassification issues, this type of program may be a way to minimize your liabilities.