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W2 Employee vs. Independent Contractor: Why it is Important to Properly Classify Your Workers (and Yourself)

Timothy Sullivan, CPA
September 27, 2022

The IRS uses a 20-factor test to determine if a worker is an independent contractor or employee. New York State follows this 20-point common law test while the State of New Jersey uses the more stringent “ABC” test.

Many employers attempt to circumvent having to put a worker on their payroll to avoid paying payroll taxes. This is short-sighted in many cases—especially when a worker misclassification can trigger a costly audit by the New Jersey Department of Labor.

IRS rules about independent contractors

The essence of determining the employee/independent contractor status falls largely on issues of payor control over the worker.

The IRS rules and common-law doctrine stipulate that independent contractors control the manner and means by which contracted services, products, or results are achieved. The amount of control a company exercises over how, when, where, and by whom work is performed determines how likely the workers are classified as employees instead.

Note that a worker does not have to meet all 20 criteria to qualify as either an employee or independent contractor, and no single factor is the determining factor of a worker’s status. It is more on a case-by-case basis and more flexible than New Jersey’s “ABC” rule.

New Jersey’s “ABC” rule for independent contractors

New Jersey’s three-part “ABC test” is used to determine classification as an independent contractor (IC), which requires the person meets all three criteria as outlined here from the Department of Labor (DOL):

  1. The individual has been and will continue to be free from control or direction over the performance of work performed, both under contract of service and in fact; and
  2. The work is either outside the usual course of the business for which such service is performed, or the work is performed outside of all the places of business of the enterprise for which such service is performed; and
  3. The individual is customarily engaged in an independently established trade, occupation, profession or business.

For example, a per diem worker who must be on the payor’s site to do a job in accordance with payor requirements, and uses the payor’s tools to do the job (such as a computer workstation) is NOT an independent contractor. He or she does not meet criterion C. Therefore, that person must be added to the employer’s payroll as a W2 employee, even if for a temporary period of time.

NJ DOL audits – triggers and downsides

The New Jersey DOL may audit a company’s payroll files if a worker is potentially misclassified as an independent contractor. The department can go back four years in NJ in general and seven years if fraud is detected. The DOL often discovers a worker’s misclassification when that person is terminated by a company as a contractor and tries to claim unemployment insurance—to which that person is not qualified to collect. This issue also comes to light when a person is injured on the job and tries to make a workers compensation insurance (WC) claim. However, the self-employed and ICs are not covered by an employer’s WC policy.

The audit results will add up if the DOL finds the worker should have been on the payroll. The business is required to pay the employer’s share of unemployment and disability insurance from company funds, in addition to what should have been withheld from the W2 employee.

One industry on the DOL radar is construction, as general contractors bring in subcontractors who may not be correctly classified as ICs.

Workers Compensation

If you are self-employed or an IC, having your own workers compensation policy protects you in the event of a workplace-related injury—and may be required by your state, depending on your entity structure and where you live. In New Jersey, it is not required for unincorporated ICs without employees,but it is required if your business is a limited liability company or hires part-time or seasonal employees. 

If you are an employer who brings in seasonal help or has been contracting with ICs—or has questions about whether you’ve been correctly classifying certain workers—the tax experts at Sullivan, Scheidel & Lanni CPA can review your records and help you determine the correct status of your team. This will help you avoid triggering a DOL audit and keep your business in compliance with federal and state employment laws. We can also help you determine if you are required to carry workers compensation insurance and the benefits of doing so.

Contact us to discuss this or any other business tax matter, or for support in the case of an audit at [email protected] or 201-236-2226.

Categories: Articles, Tax Planning

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