Don’t Get Stung With Penalties Due to Worker Misclassification

Michael Flerchinger

By Michael Flerchinger, CPA

With the continual increase of costs in ranching it is becoming ever more important to find ways to save money where you can.  A common area to cut costs is in employee wage expense.  Many people consider the strategy of hiring someone as an independent contractor (IC) versus an employee, as an automatic savings for the ranch.  Unfortunately, the IRS has realized this strategy as well – not just in the ag industry, but in all industries.  As a result, worker misclassification has become an audit focus within recent years.  It’s important to understand how to identify what establishes an employee or IC relationship, what your potential risks are if misclassified, and how can you minimize the cost of hiring employees.

The savings from classifying a worker as IC can add up quickly.  When hiring an employee, the ranch will be responsible to pay the employer’s match of FICA taxes, withhold and remit employees’ Federal and State income and FICA taxes, retirement plan costs if applicable, workers’ compensation costs, and potential unemployment taxes if the ranch pays in excess of $20,000 in wages any quarter during the year.  Clearly, the savings of having a worker being classified as an IC is tempting.  However, if it’s questionable, you should step back and analyze the factors what will help you determine the proper classification.

The IRS has a list of 20 different factors they consider in determining employee versus IC status.  Some factors carry more evidence than others and no single factor will override another.  The analysis is based solely on the facts and circumstances of the relationship.  Below are some of the factors to consider in no particular order or importance.

1. Instructions – Does the employer retain the ability to instruct how particular tasks will be performed to attain a desired result?  If so, how much detail does the employer provide to the worker?  Does the worker have to obtain approval from the employer before diverting from certain actions?
2. Intent of the Parties & Written Contracts – A written agreement describing the worker as an IC will show the parties’ intent of the relationship to be an IC.  However, a written agreement will not override the substance of the relationship if the facts and circumstances determine an employer-employee relationship.
3. Investment in Equipment or Facilities – Does the worker provide his own equipment to get the job done?  Does the worker have to provide their own materials and supplies to complete the job?  If so, there is a good case for IC status.
4. Financial Risk Assumed by the Worker – Is the worker at risk of having financial loss if the work is not done properly?  If a worker is only paid a fixed amount and is not at risk of financial loss there is a good case for employee status.
5. Permanency of Employment – Does the worker perform duties for the ranch on a continuing basis?  This is not to say that part-time employees are IC’s.  This is a case where other facts and circumstances must be weighed to determine the worker’s employment status.

 Keep in mind this is not an exhaustive list.  These factors and the facts and circumstances of each relationship, will determine the proper status.

The risks of incorrect classification can be costly.  If the IRS prevails in such a case, the business owner will likely face numerous costs.  The IRS will assess late or incorrect filing penalties related to payroll reports such as 943’s for payroll taxes, W-2’s reporting wages to employee’s, the related W-3, and the 940 relating to unemployment, if applicable.  Further, there could be potential issues from a State Department of Labor (DOL) aspect.  If the owner incorrectly classified a worker as an IC they would not have paid workers’ compensation on them.  The State DOL could assess penalties and interest to the ranch responsible for the worker.

If you must classify a worker as an employee, there are some ways in which you can minimize the costs to the ranch.  One of the unique benefits afforded to the ag industry is that payroll taxes are not withheld from employees on non-cash compensation, nor are employers required to pay the matching FICA taxes on non-cash compensation.  Non-cash compensation can be provided in a number of ways.  Some examples include the following.

1. Commodity Wages: Calves or crops such as hay or grain if your ranch raises its own feed or has a farming component to its activities.  There are specific rules to commodity wages so you should consult your tax advisor regarding this type of payment.
2. Housing Benefits: The rules can vary slightly depending on the type of entity the ranch uses so you should consult your tax advisor on the various rules and benefits of this arrangement.
3. Use of Ranch Vehicles for Personal Needs:  This comes with potential downfalls from a potential liability standpoint if the ranch vehicle is involved in an accident while the employee is on personal business so this one should be approached with caution.
4. Commodity Compensation: As an example, beef that is raised by the ranch and provided to the employee and his family.

Although it may be tempting to classify all your workers as IC’s it comes with a potentially large cost.  If you have situations where a workers’ status is questionable, you should always document why you believe they are an IC versus an employee.  Part of a good defense in any IRS or DOL audit is well-documented support for you positions.  Please contact us to discuss your personal situation for further clarification.

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