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:
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
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
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
continuation of business aren't dependent on the services performed.
Services must be
rendered personally. Not able to engage other people to do the work.
Contractor is able to assign one of their people to do the job.
Supervising and Paying Assistance
supervises and pays workers at the direction of the employer (acts as
foreman or representative of the employer).
supervises and pays workers as the result of a contract under which they
agreed to provide materials and labor. Is responsible for the results.
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.
Contractor determines his own schedule.
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
Implies that the
employer has control, is physically within the employer's discretion and
employer's premises, uses own office, desk, telephone.
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.
performed at their own pace. Salesperson works own schedule and usually
has own office.
Oral or Written
Required to submit
regular oral or written reports to the employer.
Pay by Hour,
Paid by the
employer of regular amounts as stated intervals.
Paid by the job
on a straight commission.
Business and/or Traveling Expenses
pays the worker's business and/or traveling expenses.
Takes care of
own expenses and is accountable only to themselves for expenses.
furnishes, tools, materials, etc.
Has a lack of
investment and depends on the employer for facilities.
Has a real,
essential and adequate investment.
Cannot realize a
profit or loss by making good or bad decisions.
realize a profit or suffer a loss as a result of their service.
Working for More
Than One Firm at a Time
for one employer.
Works for a
number of persons or firms at the same time.
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.
discharged at anytime.
Cannot be fired
so long they produce a result which meets contract specifications.
Can end their
own relationship with the employer at anytime.
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
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:
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.
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.
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
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:
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
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.