Who is your employee?

by Tony Novak, MBA, MT, OnlineAdviser at Freedom Benefits revised 11/16/2011

Distinguishing qualified employer /employee relationships for purposes of the various tax, government, entitlement and insurance purposes can be complex and frustrating for small business employers and their employees. The financial and legal consequences of making an error in properly identifying an “eligible employee” vs. "independent contractor" can be severe. A number of tax program, social entitlement programs, employee benefits and insurance programs are designed exclusively for "eligible employees". But how does an employer determine who is an employee? The answer varies depending on which tax provision, benefit plan, or other program under consideration. Many business owners are surprised to learn that a person who is not an employee for one type of program or wage tax is often considered an employee under another definition.

The following table is designed to point out some differences:

For purposes of:	Who is an eligible employee?	Possible consequences for incorrect classification
Federal Income Tax/FICA	The IRS makes the determination based primarily on whether the employer directs the actions of the worker as explained here. An employer cannot elect to treat common law employees as contractors. If the employer has reasonable basis for classifying workers as independent contractors IRS Form SS-8 allows employers to avoid tax penalties.	Employer is responsible for all (both employer and employee’s portion) of wage taxes plus substantial penalties and interest. IRS does aggressively pursue violators. Any “responsible person” including a bookkeeper or employee may also be personally liable for severe violations.
Worker’s Compensation	Coverage is based on the business payroll records. Any person who receives pay for service who is not covered by worker’s compensation by another employer is considered a covered employee for worker' s compensation unless a specific exemption applies. For example, owner/employees are exempted in most states.	Employer is responsible for payment of medical costs and lost wages for uncovered workers.
Health Insurance	Health insurance is always voluntary. The business may discriminate in offering coverage among employees or subcontractors without adverse tax consequences. Any person is eligible (whether employee, contractor, associate, partner, etc.) if working an average of 30 or more hours after the “waiting period” designated by the employer in the plan document. Owners are eligible for coverage but are not employees except for C corporations.	No coverage is offered for non-eligible persons if the intention was determined to be fraudulent during a claim investigation. The insurer may drop firms that are habitual offenders. Unintentional enrollment errors do not invalidate the insurance.
Sec. 125 Cafeteria Benefit Plan	Owners are not employees. Employees can be included or excluded by “class” as determined by the owner, as long as the determination does not discriminate in favor of highly paid individuals. The employer determines waiting period and employee matching.	If the plan’s eligibility determination is improper, then the entire firm’s plan benefits will be taxable for the year. If the plan benefits become discriminatory by accident during the plan year then only the excess benefits will be taxable to the highly paid person.
Simplified Employee Pension	All employees must be included who had more than $400 compensation including seasonal and part-time employees. Employees under age 25 or with less than 2 years of employment may be excluded.	All contributions for the year become taxable to each employee.
401(k) Plan or other Qualified Profit Sharing Plan	Defined by the plan document. Employers have latitude is deciding who is included.	Plan disqualification with adverse tax treatment is a possible risk, but most employers are allowed to correct any errors voluntarily when discovered without incurring tax penalties.
Private Pension and “Non-qualified” Profit Sharing Plans	Completely determined by the business owner. Discrimination is allowed. Subcontractors may participate.	No penalties.

The key point to remember is that an employee for one purpose or program by a specific definition is not necessarily an employee for another purpose or program by a different definition.

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