Independent contractor vs. employee is an issue that never seems to go away for many employers.

It’s been a regular topic on this blog since 2007.

Now there’s a new concern about employee classification on the horizon. It’s an outgrowth of the Affordable Care Act.

Case in point: “small employers” who may be eligible for a small business tax credit to help cover the cost of providing health insurance benefits to employees. Before we get to the details, let’s start with the basics.

Worker Classification Enforcement

Simply stated, an independent contractor is a self-employed person who is hired by a company or individual to perform a specific task. They are not employees of the company, and don’t receive  a paycheck, don’t have taxes withheld, and don’t receive benefits. Employees, on the other hand, do on all three counts.

Of course, it’s not that simple. Whether a worker is an independent contractor or employee is determined by the ubiquitous legal concept: “facts and circumstances”.

Thus, it’s subjective depending which of the enforcement agencies are involved, i.e., the Internal Revenue Service, the Department of Labor, and the various States. Each of which can have their own definition of what constitutes an independent contractor. The financial consequences of worker misclassification can be costly.

The IRS focuses on back taxes and penalties and whether workers should be included in retirement plans. The Department of Labor wants to know whether workers should be classified as employees and eligible for overtime, minimum wage and other rights under the Fair Labor Standards Act. The States are looking to see if employers are liable for workers compensation and unemployment taxes.

The Small Business Health Care Tax Credit

Now enter the new tax credit under the Affordable Care Act. into the employee classification mix. You can find the details here.

The key point here is this: An employer may qualify for an employer health care tax credit if it employs fewer than 25 full-time equivalent employees making an average of about $50,000 a year or less. The tax credit can be worth up to 50% of an employer’s contribution toward employees’ premium costs, and up to 35% for tax-exempt employers.

Rick Norris, a Los Angeles-based CPA, sees a potential problem. He asks the question, The Health Care Act Tax Credit: Another Battleground in the Employee/Independent Contractor Classification War? in a recent issue of  Health Care Reform Magazine.

Here’s what he says,

The law seems cut and dry, but could become complicated as the IRS set out on its mission to redefine “employee.” Take for example, an employer who employs 10 full time employees who earn less than $25,000. Since the employer pays over 50% of the employees insurance premiums, it seems that the employer should be entitled to the full Health Care Act tax credit in 2010. Two years later, the IRS performs a payroll audit and finds that the employer paid an additional 10 salespersons approximately $50,000 each and treats them as independent contractors. To the dismay of the employer, the IRS reclassifies the ten as employees and assesses heavy payroll taxes, penalties and interest on the employer for 2010 and 2011.

The next question, however, is does this reclassification invalidate the employer’s Health Care Act tax credit, assuming the ten employees push him above the eligibility thresholds?

Or, in a similar scenario what if the federal or state labor boards, instead of the IRS, audit the employer and find him in non-conformity with the labor laws by classifying employees as independent contractors as opposed to employees? Will that trigger a recapture of the Health Care tax credit taken on the business tax returns, along with penalties and interest?

My conclusion is the same as Rick’s. If you have any concerns about how you are classifying workers; consult with your tax advisor. Even if you think you’re on solid ground, consider a periodic review of how you classify your workers.

Image: TaxCalcUSA.