The biggest issue you’re going to face as a small business owner this year is whether or not the people you hire to work for you are employees or contract labor. This is such a hot topic with the IRS right now that they’re currently running a Voluntary Compliance Program—giving businesses a chance to “change their minds” about how their workers are classified. It’s called the Voluntary Classification Settlement Program (VCSP).

Basically, with the VCSP, if a business has been calling workers contract labor when they really should have been labeled as employees, you get a chance to go in and change your employee’s status before the IRS nails you instead.

So how do you know if you’ve got an employee versus a contract labor situation? That’s a really tough call sometimes and the law isn’t very clear. It’s all based on what’s known as “common law,” which means the issues have been settled in court cases instead of legislation spelling out the rules for us. The basic common law rule that defines an employee is that the service recipient (in English that’s the boss) has the right to direct and control how the service is performed.

Let me use an example: let’s say you hire me to do your taxes for you (Good idea, actually). In this case I would be contract labor to you. You will tell me what you need done, and supply me with the information to do it, but I’m going to use my software programs, my office, my stuff in general. I’m going to do it my own way, when I want to, and wear my pajamas at work if I want. That’s contract labor. (By the way, I never wear pajamas to work but I sometimes wear a St. Louis Cardinals jersey.)

But I used to be an employee at a large tax company. While I was working there, I used my boss’s software, I had certain hours that I had to be in the office, I arranged the paperwork for the files exactly as I was instructed (with the staple in the top left hand corner horizontal to the box in the big numbers in it) etc., etc.. My Cardinals jersey would have been a dress code violation and I would have been sent home. I could have even done your taxes while I was working for that company, but you weren’t really hiring me, you were hiring that company that I worked for.

You see how those two examples are different? Even though there isn’t an absolute, defining definition of what makes a person an employee, it’s sort of like Justice Potter Stewart’s famous quote about obscenity, “…I know it when I see it.”

I work with a lot of clients who are classified as 1099 contract laborers but should be labeled as employees. Most of them will never file a complaint with the IRS for fear of losing what jobs they do have, so employers have been pretty safe up until now. But the IRS isn’t stupid (Yes, I put that in writing). If I can look at a 1099 MISC and figure out that the person is really an employee instead of contract labor, the IRS is able to set up a computer screen and they’re going to be able to target suspicious 1099s as well. Did I mention, they’ve been updating their equipment? Faster, stronger, better—it’s like the $6 million man but more expensive.

So how do the people you hire stack up? If you’re paying people as employees, and properly paying your withholding taxes, then you’ve got nothing to worry about. If you’ve got employees but you’re paying them as contract labor it’s time to take a good hard look and decide if you’re doing the right thing. Using the common law test of “direct and control” are these people really contract labor or should you reclassify them as employees? If they should be called employees, you’ll want to find out more about the Voluntary Classification Settlement Program.

The VCSP has a whole list of requirements and there will be costs attached. Although that’s a little scary, it’s much better than the costs associated with an audit over your worker classification. To find more information about the VCSP, here’s a link to the IRS website: http://www.irs.gov/businesses/small/article/0,,id=246013,00.html

It’s perfectly legal to hire contract labor—it’s a very normal, regular part of business and many businesses couldn’t function without it. When you cross that line, when you’re really hiring employees but you’re just calling them contract labor to avoid paying payroll taxes– that will get you into trouble.