One of the hottest topics in the past few years with the IRS is the treatment of employee vs. independent contractor. There are major tax implications for your decision to pay your hired help as an independent contractor or an employee.
If you misclassify an employee as an independent contractor, you may be held liable for employment taxes, penalties, and interest under IRS code section 3509. These employment taxes could be significant and detrimental to the operations of the business if they are enforced. Needless to say, it is crucial to have the right classification for all workers.
Below we will discuss the difference between the two and how to determine which classification is appropriate. Let’s first start by defining each of the terms.
What is an Independent Contractor?
-Payer has the right to control the final result of the work only
-Worker has control over what will be done and how it will be done
-Not considered a contractor if the employer has control over the services you are performing
-Will receive a 1099 from the payer and will be responsible for self-employment tax on the income
-Eligible to deduct any business expenses incurred related to the job
What is an Employee?
-Payer has control over what will be done and how it will be done
-It is the right to control the work, not necessarily exercising that right (Example: employer can provide some freedom in the workplace to employees but that doesn’t make them contractors)
-Employees will receive a W-2 with required taxes withheld from each paycheck
So how do you decide if a person should be treated as an employee or a contractor? There are 3 areas the IRS uses to determine this: Behavioral, Financial and Relationship. Let’s take a look at these in more detail.
1. Type of instruction – when, where and how to do the work is typically not provided for a contractor
2. Degree of instruction – contractors require less detail about how the work should be done
3. Evaluation – an evaluation following the job for a contractor will only review the results of the job and not how the work was completed
4. Training – training is typically not provided on how the work should be done for a contractor
1. Significant investment – contractors typically have an investment in the equipment they use
2. Unreimbursed expenses – contractor is more likely to have unreimbursed expenses
3. Opportunity for profit and loss – contractor could potentially take a loss on the job since they are incurring costs
4. Services available to market – contractor is free to seek other business opportunities
5. Method of payment – contractors generally have a fixed flat fee for a particular job
1. Written contracts – IRS will not necessarily follow the treatment you have in your contract with the worker
2. Benefits – typically no benefits are provided for a contractor
3. Permanency of relationship – contractor typically has a defined length of the relationship
4. Key activity of business – contractors typically don’t provide a key activity for the business
The list above summarizes a guide directly from the IRS website. This is what they will be using to determine the status of your workers if you are audited. There is no “magic” answer how to determine the classification of workers. You need to use all the factors above to make the most educated decision possible.
Generally, classifying your hired help as a contractor is less costly to a business as the business would save on payroll taxes and benefits. Employers need to tread carefully in this area as it can be an extremely risky to “toe the line” and treat employees as contractors. We highly recommend and advise business owners to take the necessary precautions and follow all IRS protocol. Potentially having to pay back taxes and penalties will be a costly problem – it is not uncommon for a business to have to shut down operations in some instances if this occurs.
Are you classifying your workers correctly? If you are unsure, we recommend that you seek professional guidance immediately.