The Affordable Care Act (ACA) requirement that certain employers provide health insurance for their employees or pay a penalty has put employment status issues in the IRS spotlight in recent months—and the fact-intensive nature of the analysis involved has many small business clients wondering which side of the fence they fall upon. 

Unfortunately for these clients, the stakes have never been higher, and at a time where the lines between employee and independent contractor status have perhaps never been more blurred. It therefore becomes critical for advisors to help their small business clients take every precaution possible to satisfy the IRS, Department of Labor (DOL) and even state authorities in order to avoid potentially crushing penalties going forward.

Ramifications of Misclassification

Perhaps the strongest motivation for an employer to properly classify workers is the liability for retroactive employment taxes that applies if an employer is required to reclassify misclassified workers as employees. While this retroactive liability alone can be substantial, the ACA will begin to impose its own set of penalties in just a few short weeks upon employers who miss the mark when it comes to determining employment status.

Under the ACA, only those employers with 50 or more full-time employees are subject to the “employer mandate,” which requires the employer to provide employees with health insurance that meets certain minimum coverage requirements or pay a penalty. While the mandate has been delayed until 2015, the deadline is just around the corner—so small business clients should be planning now to determine whether they could cross the threshold.

Based on ACA rules, a full-time employee means a common law employee who works 30 or more hours per week for a one-month measuring period. Employers are permitted to exclude seasonal employees who work fewer than 120 days per year from the calculation. As previously noted, independent contractors are excluded from the calculation as well if they satisfy the tests set forth below.

The penalty will equal $2,000 per improperly classified worker if a reclassification causes the employer to cross the 50-employee threshold.  The penalty is increased to $3,000 per employee if the employer crosses the 50-employee threshold and is offering coverage, but that coverage is deemed to be unaffordable or fails to meet the standards for providing minimum essential health benefits.

The IRS Employment Status Test

Every small business client who engages independent contractors should be aware that a written contract setting forth the terms of the relationship is the foundation for achieving independent contractor status, but the contract alone is insufficient.  If challenged—either by the worker or the authorities—the client must also satisfy a fact-intensive test in order to determine employment status.

The IRS employs a 20-factor test in determining employment status and, in the case of a small business, every employee counts.  The analysis generally hinges on the degree of control that the employer exercises over the worker’s performance.  In other words, the question is whether the employer has the right to control not only what work will be done, but also how the worker will accomplish that work.

IRS factors that tend to be important in the analysis include whether:  

(1) the worker is required to follow the business owner’s instructions

(2) any training requirements are imposed upon the worker by a business owner

(3) there is a continuing relationship between the worker and business owner

(4) work is performed on the business owner’s premises

(5) the worker’s travel expenses are paid by the business owner

(6) the work-related tools are provided by the business owner

(7) the business owner pays for administrative support. 

Many recent cases have also drawn attention to whether the employer is permitted to fire the worker at-will, which indicates a level of control that could indicate the presence of an employment relationship. 

Conclusion

The stakes have never been higher for small business clients who engage independent contractors in the course of their business activities—so it’s critical that the practices of these clients be examined now in order to ensure proper classification in order to avoid a future challenge.

Originally published on National Underwriter Advanced Markets. National Underwriter Advanced Markets is the premier resource for financial planners, wealth managers, and advanced markets professionals who provide clients with expert financial and retirement planning advice.

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