Employee Classifications: Are You in Compliance? Safe Harbor Rules

employee classification

Employee Classifications: Are You in Compliance?

Have you ever been the subject of an IRS employee classification audit? How about struggle to differentiate between employees and independent contractors? Business owners that don’t have clear-cut distinctions between independent contractors and employees or have a mix of both find it difficult to choose the right classification.

It’s no secret that misclassifying employees is at the top of the IRS’s watch list, with the ability to charge significant back taxes, fines, and penalties associated with misclassifications. Understanding the Safe Harbor Rules for employee classifications and how you can keep your business prepared for IRS audits is essential to minimize risk and protect your business bank account from unwanted penalties.

What are the Safe Harbor Rules for Employee Classifications?

Under Internal Revenue Code Section 530, employers can bypass the Common Law Rules for differentiating between an employee and an independent contractor. Typically, employers are required to classify the worker as an employee if the following three tests are met:

  1. Behavioral – The employer controls the day-to-day tasks of the worker.
  2. Financial – The employer controls the pay and reimbursement ability of the worker.
  3. Relationship – The employer provides benefits and determines the contractual relationship.

Even if you meet the Common Law Rules, the Safe Harbor Rules outlined in Section 530 allow your organization to bypass employer liabilities associated with employee status and classify the worker as an independent contractor if the following three requirements are met:

  1. Reporting Consistency – You have always filed the correct forms associated with independent contractors, which is Form 1099.
  2. Substantive Consistency – Your company has not treated the same worker position as an employee in the past.
  3. Reasonable Basis – Your business has relied on a prior audit, judicial precedent, or industry practice when making the employment classification decision.

What are Ways to Prepare for IRS Employee Classification Audits?

If your business does get audited for employee classifications, there are ways you can prepare. The IRS requires you to establish a prima facie case that it was reasonable to classify the workers as independent contractors. The burden of proof to support your position falls on you as the business owner. Before the audit begins, be sure you have enough primary support to substantiate your position, such as a prior audit, judicial precedent, or industry practice guidelines.

Even if your business hasn’t been selected for an audit, it’s important that you implement best practices, especially when using Section 530. First, review all of your existing independent contractor agreements to ensure they meet the criteria in Section 530. Next, obtain Form W-9 from each worker before work begins and issue a 1099 each year when the worker meets the reporting requirement.

In addition, you should watch for IRS Form SS-8 requests that indicate a worker classification audit might be on the horizon. Finally, do not flip flop between employees and independent contractors for the position. Once you determine that the worker is an employee or independent contractor, stick with that classification. Following these steps can help you avoid any penalties associated with your worker classifications under Section 530.


Are you confident in your employee classifications? If not, it’s time to reach out to our team of SMAART accounting experts that can analyze your current employee classifications to pinpoint weaknesses that the IRS might exploit. Reach out today to schedule a consultation.

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