The relationship between an employer and a worker is not always straightforward, but despite the possible discrepancies, it is extremely important to properly classify your workers. Tax implications vary depending on the type of worker, and the penalties for misclassifying a worker can be huge.
Generally, the Internal Revenue Service states you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. However, a business owner is not responsible for any payroll taxes for independent contractors.
Many companies believe that they can choose whether to treat any given worker as an employee or independent contractor, but there are laws that determine whether a worker is an employee or an independent contractor.
Employee or Independent Contractor?
Before determining how to treat payments your company makes for services, you must categorize the business relationship that exists between your company and the person performing the services. The two largest categories of works are: employee or independent contractor.
Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done, even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed, such as when and where to do the work, what tools or equipment to use, where to purchase supplies and services, or what work must be performed by a specified individual.
In contrast, an independent contractor is an individual who performs services for you, but you control only the result of the work, not the means and methods of accomplishing the result.
People such as doctors, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers or auctioneers who are in an independent trade, business or profession in which they offer their services to the general public are generally independent contractors. However, whether these people are independent contractors or employees depends on the facts in each case. The general rule is that an individual is an independent contractor if the payer 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 determining if a worker is an employee or an independent contractor, a key factor to consider is whether the business retains the right to control the worker and the details of how the services are performed, regardless of whether the business actually exercises that right.
Here’s an example:
A plumber agrees to install plumbing in a new warehouse being built. Upon arriving at the warehouse, the plumber is given the building plans showing where the plumbing is to be installed, and advised that the plumbing must be completed within five days. This is direction of what is to be done, rather than how it is to be done and is consistent with independent contractor status.
Here’s another example that points more to an employee:
A plumber works out of the local plumbers’ union office. The warehouse general contractor tells the plumber what plumbing has to be done, gives specific instructions on installation, the tools to use, the type of pipe to use, and the order and sequence in which the plumbing is to be installed. These are specific instructions on how the work is to be performed and are consistent with employee status.
Types of Employees
- Statutory Employee: If workers are independent contractors under the common law rules, such workers may nevertheless be treated as employees by statute (statutory employees) 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.
- A driver who distributes beverages (other than milk), meat, vegetable, fruit or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.
- A 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.
- An individual who works at home on materials or goods that you supply and that must be returned to you or to a person of your name, if you also furnish specification for the work to be done.
- A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, 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 you must be the salesperson’s principal business activity.
- Social Security and Medicare taxes: Withhold Social Security and Medicare taxes from the wages of statutory employees if all three of the following conditions apply:
- The service contract states or implies that substantially all the services are to be performed personally by them.
- They do not have a substantial investment in the equipment and property used to perform the services (other than an investment in transportation facilities).
- The services are performed on a continuing basis for the same payer.
- Statutory Non-employee: There are generally 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:
- Substantially 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
- Their services are performed under a written contract providing that they will not be treated as employees for federal tax purposes.
- Part-time Workers: Businesses often need to hire workers on a seasonal or part-time basis. Whether you are getting paid or paying someone else, questions often arise over the tax treatment of payments for part-time and seasonal help. Part-time and seasonal employees are subject to the same tax withholding rules that apply to other employees.
If you have misclassified workers,
In certain circumstances, the IRS can relieve businesses of certain tax liabilities resulting from worker misclassification, but the business must meet specific requirements under the law.
The business must meet the following three requirements to receive relief:
- Reporting consistency: the business must treat all workers in a similar position the same.
- Substantive consistency: the business must file all required federal tax returns on a consistent basis.
- Reasonable basis: The business must also have a reasonable basis for not treating the workers as employees.
Because not every worker can be easily classified in one category, it is important to take the entire working relationship into account. Consider the extent of the right to direct and control the services of the worker. And after you’ve classified the worker, document each of the factors used to determine how you came to your classification decision. Remember, the financial impact of misclassifying a worker can be substantial.