Every business needs workers. So as a small business owner, you must determine how you want to classify the people who work in your company. Basically, this means you have to choose between designating your workers as employees or as independent contractors.

However, I must stress that this decision must be made with great care and deliberation. Indeed, it is imperative that you categorize your workers correctly or you could face severe federal and/or state tax consequences.

In this post, I’ll provide an overview to help you understand the best approach to take in making these worker classification decisions.

Circumstances for Worker Classification

There are a number of circumstances that can make worker classification an issue to business owners. These situations include:

  • When a new business is looking to set up efficient management and accounting practices such as small business tax preparation;
  • When an existing business is downsizing to reduce operating expenses and payroll taxes; and
  • When a flourishing business is expanding its staff to increase productivity.

In each one of these circumstances, proper labor classification is immensely important. Both state and federal taxing authorities monitor and regularly conduct audits of businesses, with the hope of being able to impose significant retroactive penalties and interest on a business that is determined to have improperly classified employees as independent contractors.

The “Right to Control”

To discover whether or not a business has accurately classified its workers, both the state and the federal government have devised lists of factors that can be applied to the company’s structure. The purpose of each point is to determine how much control you as the owner have over your workers. The more control you exercise, the more likely it is that your business is staffed by employees, not independent contractors.

This “right to control” essentially means that you actively supervise, provide tools and convey clear expectations of how your workers should use their time fulfilling certain roles within your company. In other words, if you inspect an individual’s output, give him set hours on work days and, overall, direct his performance for you, then you are subject to paying state and federal employment taxes, Workers’ Compensation and other fees that correspond with hiring permanent employees.

State and Federal Factors

Illinois common law examines ten different factors in its “right to control” test designed to distinguish between employees and independent contractors. Although the emphasis on these factors may fluctuate, control is still the key.

The Illinois Department of Employment Security (IDES) has devised its own strict test for evaluating the status of a worker. While the IDES only considers three (3) factors, its strict pro-employee consideration of these factors almost always results in a finding that the worker is an employee, not an independent contractor. Therefore, a business owner, who has mistakenly classified his workers as independent contractors, may be forced to pay harsh penalties and interest to IDES.

On a federal level, the IRS conducts its own evaluation of worker classification based on twenty factors. Like the IDES test described above, the federal test also tends to favor a finding of a worker as an employee rather than an independent contractor. As a result, an employer could be compelled to pay an exorbitant amount of taxes, penalties and interest to the IRS, retroactive to the date of hire of the improperly classified worker.

Defending Your Business

Now that you understand what’s at stake when it comes to classifying your workers, let’s discuss how you can prevent state and federal authorities from re-classifying the categorization of your staff in a way that makes you susceptible to enormous penalties.

First of all, you need to familiarize yourself with the different factors that the state of Illinois and the federal government apply to determine worker status. Secondly, you must structure your business so that you cannot be deemed to have a “right to control” your workers. You can achieve this outcome by making your workers truly independent from your company. For example, each independent contractor must be their own separate, incorporated business with company names and business cards.

Next, you should have each corporate worker sign an Independent Contractors’ Agreement with you which includes explicit language that declares each person as independent with no obligation to you. The agreement should specify that your independent contractors can and do work for other people. So they are not tied exclusively to your business. This move minimizes the “right to control” aspect that is such a core factor to both Illinois and the federal government.

It may seem uncomfortable at first to take such extraordinary steps. But you have to keep in mind that if you don’t protect your worker classification, you could be subject to a grueling audit that will be both costly and a serious threat to the future of your business.

In my next post, I will look more closely at some of the factors that the state and federal governments use. That way, you will better understand how these factors work as a whole.