As the use of contract labor increases among small business so does the interest of the Internal Revenue Service and certain state employment departments. Government agencies have therefore, become very aggressive in efforts to ensure that all persons performing work are categorized properly. This interest, in part, stems from the suspicion that companies are using contract labor to avoid the withholding and payment of payroll taxes. If an individual is classified as an independent contractor and the IRS later rules that the individual should be an employee, the business can be held liable. The resulting penalties could include: back taxes; penalties and interest on Social Security; state and federal unemployment negligence; fraud; and state and federal withholding taxes.
The IRS describes two classes of workers as independent contractors. These are direct sellers and licensed qualified real estate agents. The status of other classes of workers is determined through application of the Common Law test. The Common Law Test is designed to analyze the level of control you, as an employer, exert over the worker. The more control you posses (especially over the method of accomplishing a task rather than the end result), the more likely a worker is an employee. The definition of control is defined by the level of legal right to direct rather than the direction actually provided.
IRS Publication 539 Employment Taxes will provide answers to some questions on the federal level. State requirements defining employees should also be investigated. It is common for the question to come up at the state level should an individual apply for unemployment. IRS Form SS-8 is designed to provide guidance to the business regarding employment classifications.