Employee or Independent Contractor?

Suppose your business hires an outside person to complete a task. What is your tax withholding responsibility when you pay this person? The answer depends on the business relationship between you and the person doing work for you.

Types of workers

There are two kinds of workers: employees and independent contractors. (We know this is a very simplified statement, but we want to make you aware of a potential tax issue without writing an entire encyclopedia.) An employee is a person hired by an employer or business to do a job in exchange for a wage or salary. The employer usually tells the worker what tasks to do, sets their schedule, and controls how the work gets done. Employers usually provide the worker with a place to do the work and any tools necessary to accomplish a task.  Many employees receive benefits such as medical insurance or retirement plans. Most importantly, the employer is responsible for withholding federal, state, and payroll taxes from the employee’s pay and for paying unemployment taxes.

An independent contractor is a self-employed person or business hired to do specific tasks or projects for a client. They generally charge by the project, hour, or milestone, and submit invoices for payment. Independent contractors do not usually receive benefits, and they are responsible for paying their own income and self-employment taxes.

Why does correct classification matter?

Before paying someone for work they perform, it is critical that you understand whether they are an employee or independent contractor because you and the IRS have competing interests regarding worker classification. The IRS would like to classify all workers as employees since this relationship provides safeguards to ensure all parties comply with tax laws. Employers are required to make periodic tax deposits and must report a worker’s income and tax withholding at the end of the tax year. Individuals don’t have the same tax deposit requirements that employers do, and it is easier for them to hide income and thus pay less than a fair tax.

Besides improving tax compliance, the rules governing paying employees also encourage fairness by preventing  companies from shifting tax burdens and administrative costs onto workers.

Employers tend to be better off financially if all workers are independent contractors. They don’t have to pay half of a worker’s social security and Medicare taxes, and don’t have to pay for worker benefits. Administrative costs can be lower because issuing 1099 forms to report payments requires less recordkeeping than providing W-2 forms to employees.

Worker classification is a top enforcement priority for the IRS. Misclassifying an employee as an independent contractor is considered a payroll tax compliance issue by the IRS, so  consequences for getting it wrong are harsh and can include audits, penalties, interest, and back payroll tax bills.

Not always an easy determination

You cannot rely on job titles or written agreements alone to justify treating a worker as an independent contractor. The IRS will look at how the relationship functions in practice. There is no definitive test for determining worker classification. Instead, IRS applies a “common law” test that is somewhat nebulous but generally focuses on independence and the degree of behavioral and financial control the business has over the worker.

To make matters even more complicated, the IRS and the Department of Labor (DOL) each have their own definitions of what an independent contractor is. This means that some workers who may be classified as independent contractors for tax purposes may be employees for DOL purposes. The DOL laws are beyond the scope of this article, but if you want or need more information about them, we can point you to an expert who can help.

Categories of control

Facts that provide evidence of the degree of control and independence fall into three categories:

• Behavioral – Does the company have the right to control what the worker does and how the worker does their job? Does the company provide training on how the work should be done? More control on the part of the company implies the worker is an employee.
• Financial – Are the business aspects of the worker’s job controlled by the payer? Can the worker realize a profit or loss from their work? How the worker is paid, whether expenses are reimbursed, and who provides tools and supplies are considered in this category. If the worker does not have a risk of financial loss, they are likely an employee.
• Type of relationship – Are there written contracts or employee type benefits? Will the relationship continue? Is the work performed a key aspect of the business? If the work is part of the day-to-day operations of the business and the term of work is indefinite, the worker is likely an employee.

There is no magic or set number of factors that make a worker and employee or an independent contractor, and no one factor stands alone in making this determination. For example, the mere presence of a signed contract is not enough to classify a worker as an independent contractor. The key is to look at the entire relationship and consider the extent of the right to direct and control the worker. An individual is an independent contractor if the person for whom the services are performed has the right to control or direct only the result of the work and not what will be done and how it will be done.

When you have made a worker classification determination, it is good practice to document each of the factors used in making your decision.

Red flags

If you have classified a worker as an independent contractor, here are some red flags that can indicate that the person should really be an employee:

• You require specific work hours, fixed shifts, or full-time availability.
• You provide the worker with a company email address, an internal job title, or inclusion in routine staff meetings.
• You provide the worker with training rather than using the worker’s independent skills, training, and initiative.
• You pay regular weekly, biweekly, or monthly wages rather than a flat fee per project.
• You cover the worker’s day-to-day business expenses or travel costs.
• You forbid the worker from taking on other clients or offering services to competitors.
• The working relationship has no specific end date or project scope.
• The tasks performed are part of the main business operations of the company, rather than specialized, temporary support.

Conclusion

Making a worker classification decision is not straight-forward. If you have questions or if we can help you make an employee/independent contractor determination, give us a call. One of our tax professionals would be happy to help.