IRS Questions Answered: Have You Classified Your Employees Correctly?

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When you’re a business owner it’s up to you to classify your employees. You need to know the rules and difference between an employee vs. an independent contractor, or it could cost you a lot in the long run. Keep reading to learn more. 

Employee vs. Independent Contractor

Your business could pay an independent contractor and employee for similar or the same work. However, there are crucial legal differences between the two that you must know. With your employees, your company will withhold income tax, Medicare, and social security from wages paid. 

Independent contractors, on the other hand, do not withhold their taxes. Also, employment and labor laws do not apply to independent contractors. To tell if a person is an employee or independent contractor, the company has some factors that determine the degrees of control it has with the relationship of this person. 

For example, does the company have the right to control or controls how the worker does their job and what the worker does? Does the company also control any business aspects of the workers’ job like who provides supplies or tools, how the worker is paid, and if expenses are reimbursed?

The other thing to consider is if there is a written contract, or any employee benefits such as insurance, vacation pay and or a pension plan? Also if the relationship will still go on and if work is the main aspect of the business? 

Once you figure out the answers to these questions, know that The Internal Revenue Service (IRS) has the right-to-control test which assesses your business’ tax liability. You can visit the IRS website and check out the disclaimer page for more information.

Also, know that each state has its own tests that can determine a person’s status under unemployment insurance and worker compensation laws. There’s also the economic realities test that most states use which make it harder to classify a worker as an independent contractor.

This is because, in addition to the control test, it considers the worker to be economically dependent on the business. There is also state-specific information you can find from your state workforce agencies’ disclaimer page on their website. 

Why A Worker’s Status Is Important

It’s important that you are able to tell your employees and independent contractors apart. The status of someone who works for you makes a huge difference in how you pay them and how they pay their taxes. 

Your employees are sometimes called “common law employees” and they are paid either one salary, on commission, hourly, or a combination. Employees may also get overtime and are taxed on their income with a W-2 which shows their annual income.

As their employer, you have to withhold state and federal income taxes, as well as FICA taxes (Social Security and Medicare). Your company is also required to make FICA tax payments. 

Independent contractors, on the other hand, you don’t withhold state or federal income taxes. Your business is also not required to make any payments for FICA taxes for whatever amount you are paying them.

It is the independent contractor’s responsibility to pay his or her own income taxes which is also known as self-employment taxes, along with their income tax on their earnings. 

How Does the IRS Determine Worker Status?

There isn’t an overall way for the IRS to know if a worker is an independent contractor or employee. The IRS takes each situation case-by-case. There are some guidelines the IRS uses which you can use to see how your workers fit into one category or the other. 

The IRS needs to know which employees are independent contractors or employees for the purpose of withholding and payroll taxes. Essentially, an independent contractor is an independent business person who runs his or her own business but also does work for other businesses. 

While an employee is hired to perform specific work at the company at the orders of the employer. There are some more ways you can distinguish the difference between employees and independent contractors, here are the IRS’ general criteria. 

Behavioral Control

If the employer directs and trains the employee’s work, which includes the hours the employee works, what equipment and tools are used, specific tasks that are performed and how the work is done, then that worker is probably an employee. 

On the other hand, if the worker sets his or her own hours and works with little or no training or direction, then that worker is probably an independent contractor.

Financial Control

This includes how the worker is paid, if the worker can work for others at the same time, and if that worker can incur a loss or profit. A worker who is paid a salary is prevented from working for others and is likely an employee. If a worker is salary and can work for other companies, they are probably an independent contractor. 

Type of Relationship

A contract can indicate if a worker is an employee or an independent contractor, but this alone is not controlling. If a worker gets benefits, this would make that would show what the employment relationship is. 

Another factor would be what the type of work is that the worker does. If the work is directly related to the company’s core work, that person is likely an employee. For example, a maintenance worker isn’t doing “company” work if that worker does work for a bank. 

The IRS Always Assumes Workers Are Employees 

It might be difficult to decide the status of a worker, but if you are unsure, you should assume the worker is an employee. This is because this is what the IRS does. If you want to find out if a worker is an independent contractor or employee, you can file a Form SS-8 and request that determination from the IRS. 

The IRS won’t issue a determination on situations that are hypothetical. This is stated in form SS-8 which should be submitted to resolve any federal tax issues. You can see the IRS article on  “Independent Contractors vs. Employees” to get more details on this. 

Another Possible Status for Workers

And to confuse things even more, there is actually another worker status called a statutory employee also known as a non-employee. This type of worker is a blend between an independent contractor and an employee, and is treated as a worker outside of the company, but is also treated as an employee for tax reasons. 

There are only four types of specific categories of workers who can be called statutory employees. This includes drivers who distribute (non-milk) beverage, produce, meat, or baked goods. If they are agents of your company they are paid on a commission. 

Another category is full-time life insurance agents who sell insurance mainly for one company. There are also piece works that work at home on good or materials that you supply and you are specifying the work done and the materials or goods are then returned to you.

And lastly, a traveling salesperson fits this category as the work they perform is their main business. This person takes orders to you and the good that are sold are then merchandised for supplies or retail used in the buyer’s business. The IRS has a page on Statutory Employees with more details on what is required for this status.

Supreme Court Decisions Relating to Independent Contractor Status

You should also be aware that The Department of Labor does rely on Supreme Court decisions for independent contractors. These decisions show that there is not one single rule that tests for an independent contractor or employee for the FLSA. Some of these factors can include.

How the services are rendered and if they are a key part of the business. How permanent the relationship is, how much the contractor invests in facilities and equipment, and opportunities for loss and profit. Also the amount of judgment, initiative, or foresight in the open market as well as the degree of independent business operation and organization. 

Other factors include where the work is performed if the contractor is licensed by the government or states if there are a formal employment agreement and the time or mode of payment. 

Consequences of Misclassifying an Employee

So what happens if you misclassify an employee? If you classify an employee as an independent contractor and you have no reasonable basis for doing this, the employer is then liable for employment taxes.

There are certain employers who can provide a reasonable basis for not treating a worker as an employee and they may have the opportunity to not pay employment taxes, which you can see in Publication 1976, under Section 530 of the Employment Tax Relief Requirements.

There is also the Voluntary Classification Settlement Program (VCSP) which provides some businesses that are eligible the option to reclassify their workers. That way they can get some relief from federal employment taxes.

The IRS is able to help employers decide the status of their workers with Form SS-8. If a worker believes he or she is an employer and was improperly classified as an independent contractor, they can use Form 8919. This will help them figure out and report their uncollected Medicare and Social Security that is due to their compensation.

Properly Classify Your Employees Today 

Now that you know the difference between an employee vs independent contractor, make sure you are properly classifying your workers. For more tax resources, check out our blog.

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