How workers are classified has major tax consequences, because employees and independent contractors are treated differently for tax purposes. Potential disasters await any business if the worker is classified improperly. Improper classification can cause problems that could result in substantial payroll tax liabilities assessments for numerous prior tax periods or tax years that could have a significant financial impact on the business owner. These circumstances could even financially destroy a business.
Government entities, interested or damaged third parties, and perhaps even the worker himself will often later challenge the classification as independent contractor for a variety of reasons. Enormous tax problems can result from improper classification.
People such as lawyers, contractors, subcontractors, public stenographers, and auctioneers who follow an independent trade, business, or profession in which they offer their services to the public, are generally not employees. However, whether such people are employees or independent contractors depends on the facts and circumstances of each case. The earnings of a person who is working as an independent contractor are subject to Self-Employment (SE) tax.
The taxpayer must first know the business relationship that exists between him and the person performing the services.
The person performing the services may be:
·An independent contractor
·A common-law employee
·A statutory employee
·A statutory nonemployee
In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence should be considered.
It is critical that the employer correctly determine whether the individual providing services is an employee or independent contractor. Generally, employers must withhold income taxes and Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee and the company portion of Social Security and Medicare taxes. They do not generally have to withhold or pay any taxes on payments to independent contractors unless that person has failed to provide either a social security number or EIN on Form W-9.
If an employer incorrectly classifies an employee as an independent contractor, they can be held liable for the employment taxes for that worker, plus a penalties and interests.
Who is an Independent Contractor?
A general rule is that if the employer has the right to control or direct only the result of the work done by a person, and not the means and methods of accomplishing the result, then that person is an independent contractor.
The IRS has developed several common law factors which are used on a case by case basis to determine whether a worker is an independent contractor or an employee. Independent contractors do not have to satisfy all of the twenty common law factors. It is best to think of the factors as weights on a balance scale. Use the table below to review the 20 common law factors for determining whether the worker is an employee or independent contractor.
The 20 Common Law Factors
Complies with instructions about when, where, and how work is to be performed.
Works their own schedule. Does the job their own way.
Trained by an experienced employee working with them. Required to take correspondence courses. Required attendance at meetings and by other methods indicates that the employer wants the services performed in a particular method.
Uses their own methods and receives no training from their customer.
Services of the individual are merged into the business. Success and continuation of the business depends upon services. Employer coordinates work with that of other workers.
Success and continuation of business aren’t dependent on the services performed.
Services Rendered Personally
Services must be rendered personally. Not able to engage other people to do the work.
The Independent Contractor is able to assign one of their people to do the job.
Hiring, Supervising and Paying Assistance
Hires, supervises and pays workers at the direction of the employer (acts as foreman or representative of the employer).
Hires, supervises and pays workers as the result of a contract under which they agreed to provide materials and labor. Is responsible for the results.
The individual continues to work for the same person year after year.
Hired to do one job. There is no continuous relationship.
Set Hour of Work
The hours and days are set by the employer.
The Independent Contractor determines his own schedule.
Full Time Required
Must devote full time to the business of the employer. The employer restricts the employee from doing other gainful work.
Free to work when and for whom they choose.
Doing Work on Employer’s Premises
Implies that the employer has control, is physically within the employer’s discretion and supervision.
Works off employer’s premises, uses own office, desk, telephone.
Order or Sequence Set
Performs services in the order or sequence set by the employer. Salesperson reports at the office at specified times, follows up on leads and performs certain tasks at certain times.
Services performed at their own pace. Salesperson works own schedule and usually has own office.
Oral or Written Reports
Required to submit regular oral or written reports to the employer.
Submits no reports.
Pay by Hour, Week, Month
Paid by the employer of regular amounts as stated intervals.
Paid by the job on a straight commission.
Payment of Business and/or Traveling Expenses
The employer pays the worker’s business and/or traveling expenses.
Takes care of own expenses and is accountable only to themselves for expenses.
Furnishing of Tools, Materials
Employer furnishes, tools, materials, etc.
Furnishes own tools.
Has a lack of investment and depends on the employer for facilities.
Has a real, essential and adequate investment.
Realization of Profit/Loss
Cannot realize a profit or loss by making good or bad decisions.
Can realize a profit or suffer a loss as a result of their service.
Working for More Than One Firm at a Time
Usually works for one employer.
Works for a number of persons or firms at the same time.
Making Service Available to General Public
Does not make their own services available except through some company or business they do not have an interest in.
Has own office assistants. Holds business license, listed on business directories or maintains business telephone. Advertises in newspaper, etc.
Right to Discharge
Can be discharged at anytime.
Cannot be fired so long they produce a result which meets contract specifications.
Right to Terminate
Can end their own relationship with the employer at anytime.
Agrees to complete a specific job. Is responsible for its satisfactory completion or is legally obligated to make good.
If a worker clearly is an independent contractor, a complete agreement to that effect is useful and recommended; however, any agreement, no matter how well drafted and explained to each party and signed, will not change the results if a person is held to be an employee under the facts and circumstances.
How should payments made to independent contractors be reported?
The employer may be required to file information returns to report certain types of payments made to independent contractors during the year. For example, the employer must file Form 1099-MISC, Miscellaneous Income, to report payments of $600 or more to persons not treated as employees for services performed for the trade or business.
Who is a Common-Law Employee?
Under common-law rules, anyone who performs services is an employee if the employer can control what will be done and how it will be done. This is so even when the employer gives the employee freedom of action. What matters is that the employer has the right to control the details of how the services are performed.
To determine whether an individual is an employee or independent contractor under the common law, the relationship of the worker and the business must be examined. In an employee-independent contractor determination, all information that provides evidence of the degree of control and degree of independence must be considered.
Who is a Statutory Employee?
If workers are independent contractors under the common law rules, such workers may nevertheless be treated as employees by statute for certain employment tax purposes if they fall within any one of the following four categories and meet the three conditions described under Social security and Medicare taxes , below:
·A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is the employer’s agent or is paid on commission.
·A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.
·An individual who works at home on materials or goods that the employer supplies and that must be returned to the employer or to a person the employer names, if the employer also furnish specifications for the work to be done.
·A full-time traveling or city salesperson who works on the employer’s behalf and turns in orders to the employer from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer s business operation. The work performed for the employer must be the salesperson s principal business activity.
Who is a Statutory Nonemployee?
There are two categories of statutory nonemployees: direct sellers and licensed real estate agents. They are treated as self-employed for all Federal tax purposes, including income and employment taxes, if:
·Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked, and
·Their services are performed under a written contract providing that they will not be treated as employees for Federal tax purposes.
Misclassification of Employees
If the employer classifies an employee as an independent contractor and has no reasonable basis for doing so, the employer may be held liable for employment taxes for that worker. Improperly classified employees can cause business owners to end up with hefty tax penalties for nonpayment of employment tax. Those who need help deciding if their workers are employees or independent contractors can submit Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Tax and Income Tax Withholding to the IRS. The IRS will tell them if their workers are employees or independent contractors.