Few areas of tax law are murkier than—or can get a business in as much trouble as—the laws relating to classifying workers as employees versus independent contractors. The IRS and labor agencies aggressively pursue companies that intentionally—or unintentionally—classify someone as an independent contractor yet treat them as an employee. The IRS has gone after huge corporations as well as small businesses, and once they find a violation, they’re likely to go back through many past years of your taxes. So be careful.
Many companies would prefer to classify workers as independent contractors rather than employees. Here’s why:
And some workers would rather be classified as independent contractors. Here’s why:
While classifying workers as independent contractors may benefit you financially, even if both you and the worker agree to such classification, employment laws limit that choice. So it’s important to understand the basic outline of what makes an employee an employee and under which circumstances you can classify them as an independent contractor.
Criteria for employee vs. independent contractor
In a nutshell, the question of who “controls” the worker determines that worker’s status. The more control you have over the worker—such as when, where and how they work—the more likely the worker is your employee. The nature of the work they do for you does not alone determine their status.
The IRS and other government agencies prefer employers to classify their workers as employees. Why? Federal, state and city governments want to make certain that anyone doing the work of an employee gets treated as such. Employees are entitled to many legal protections, including rules regarding overtime and unemployment. And the government wants to protect as many workers as possible.
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Form 1099-MISC for Independent Contractors
For each and every independent contractor you pay $600 or more in any calendar year, you must complete and file a Form 1099-MISC, which reports miscellaneous income to the IRS. It is due no later than January 31 of the year following the one in which the independent contractor worked for you. You must also give the independent contractor a copy of the 1099-MISC form by the same due date.
Also, because employers are legally responsible to withhold tax money from employees’ salaries, government agencies can depend on receiving full, timely tax payments. Independent contractors, on the other hand, invoice employers and receive paychecks from which no deductions have been withheld. They manage their own tax payments and can be less reliable about submitting their taxes.
If you misclassify a worker, penalties will likely include fines and back taxes for:
The IRS’ unclear guidelines make classifying independent contractors even more difficult. However, the main issue the IRS uses to determine employee status is who “controls” the worker. The IRS once had a list of specific rules governing independent contractor status, but, responding to the legitimate needs of businesses for greater flexibility in hiring independent contractors, made the rules broader.
But this means there’s more room for misunderstanding. The IRS looks at three areas:
1. Behavioral. Does the worker control how they do the work? The IRS looks at issues such as who determines the employee’s work hours and location, who controls the order or sequence of the employee’s work processes and who owns the tools or equipment the worker uses to get the job done.
2. Type of relationship. How permanent is the relationship? Is the work performed a critical and regular part of the business? Is there a written contract? Is the worker responsible for their own benefits?
3. Financial. Does the worker have a significant investment—i.e., do they own their own tools? Do they make their services available to other and/or work for other businesses?
Because the rules are somewhat fuzzy, the IRS does provide some protections for businesses that make mistakes in treating employees as independent contractors—as long as those mistakes were made in good faith. They’ll investigate whether a business relied on the advice of an attorney or accountant, followed industry practice, and acted consistently.
Here’s More from the IRS:
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another. The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.
—U.S. Internal Revenue Service
But—and this is important—there’s absolutely no protection for a company that doesn’t file the necessary tax forms for independent contractors. Each year, you must file 1099-MISC forms which report payment to independent contractors over a certain dollar figure. If you fail to file 1099’s and the IRS later challenges you on the classification of your independent contractors, you’re in very hot water.
Review the “Right Classification” Table for the criteria the IRS uses to evaluate control of a worker and therefore how they are classified. Remember, you run into danger by misclassifying an employee as an independent contractor, and never the other way ‘round. The IRS won’t tell you that you should have classified an employee as an independent contractor.
If you have doubts about how to classify a new worker, request an employee status determination from the IRS. To do so, both you and your employee will file IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, available online at www.irs.gov. Until you hear back from the IRS, deduct and submit taxes as you would for an employee. If the IRS decides your employee is a contractor, you can apply for a refund of those taxes. If the IRS decides your employee is in fact an employee, you have saved yourself time, money and a headache.
If you plan on using independent contractors in addition to employees, ask your attorney about how to stay well within the law, and check with your accountant about filing all necessary tax forms.
Employee vs. Independent Contractor: The Right Classification
| EMPLOYEES… | INDEPENDENT CONTRACTORS… |
| Do not run their own business | Are independent business people, especially if they are incorporated |