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Independent Contractors: Classify Carefully

Many businesses use independent contractors to help keep their costs down and provide flexibility for short-term needs. But the question of whether a worker is an employee or an independent contractor is complex. Be careful that your independent contractors are properly classified for federal tax and employment tax purposes, because if the IRS reclassifies them as employees, it can be an expensive mistake.

Differing Obligations

If a worker is an employee, your company must withhold federal income tax and the employee’s share of Social Security and Medicare taxes, pay the employer’s share of Social Security and Medicare taxes, and pay federal unemployment tax. State tax obligations may also apply. A business generally must also provide that worker with fringe benefits if it makes them available to other employees.

However, if a worker is an independent contractor, these obligations don’t apply. In that case, the business simply sends the contractor a Form 1099-NEC for the year showing the amount paid (if it’s $600 or more). The contractor is responsible for paying self-employment tax and, generally, making estimated tax payments for income tax purposes in relation to the amount paid.

Key Factors

Who’s an “employee?” Unfortunately, there’s no one definition of the term. The IRS and courts have generally ruled that one of the key factors that determines the difference between an employee and a contractor is the right to control and direct the person in the jobs they’re performing, even if that control isn’t exercised. The issue of control is evaluated by asking several questions, including:

  • Who sets the worker’s schedule?
  • Are the worker’s activities subject to supervision?
  • Is the work technical in nature?
  • Is the worker free to work for others?

 

Another important factor is whether the worker has the opportunity for profit or loss based on his or her managerial skills. That is, can the worker apply independent judgment and business acumen to affect the success or failure of the work being performed? If there’s a lack of such opportunity, that’s one indication of employee status.

Section 530 Relief

Some employers that have misclassified workers as independent contractors may get some relief from employment tax liabilities under Section 530. This protection generally applies only if an employer meets certain requirements. For example, the employer must file all federal returns consistent with its treatment of a worker as a contractor and it must treat all similarly situated workers as contractors. Be aware, Section 530 doesn’t apply to certain types of workers.

Think Carefully Before Asking the IRS

You can ask the IRS (on Form SS-8) to rule on whether a worker is an independent contractor or employee. However, you should also be aware that the IRS has a history of classifying workers as employees rather than independent contractors.

So, before you file Form SS-8, contact the office for a consultation. Filing this form may alert the IRS that your business has worker classification issues, and it may unintentionally trigger an employment tax audit. It may be better to properly set up a relationship with workers to treat them as independent contractors so that your business complies with the tax rules.

Workers and Form SS-8

Workers who want an official determination of their status can also file Form SS-8. Dissatisfied workers you’ve treated as independent contractors may do so because they feel entitled to employee benefits and want to eliminate their self-employment tax liabilities. If a worker files Form SS-8, the IRS will notify the business with a letter that identifies the worker and includes a blank Form SS-8. The business will be asked to complete and return the form to the IRS, which will render a classification decision.

Importance of Correct Classification

The correct classification of workers is crucial to avoid costly penalties and legal complications. Misclassifying employees as independent contractors can lead to back taxes, interest, and fines. It’s essential to understand the rules and maintain accurate records of your workers’ statuses.

IRS and Worker Classification

The IRS uses a three-factor test to determine whether a worker is an employee or an independent contractor. These factors are:

  • Behavioral Control: Does the company control or have the right to control what the worker does and how the worker does the job?
  • Financial Control: Are the business aspects of the worker’s job controlled by the payer? (e.g., how worker is paid, whether expenses are reimbursed, who provides tools/supplies)
  • Type of Relationship: Are there written contracts or employee-type benefits (e.g., pension plan, insurance, vacation pay)? Will the relationship continue and is the work performed a key aspect of the business?

Common Law Rules

The IRS also considers common law rules which focus on the degree of control and independence in the relationship. These rules further analyze behavioral, financial, and relational aspects to assess the correct classification of workers.

Consequences of Misclassification

The consequences of misclassification can be severe. Businesses may face penalties, back taxes, and interest charges. Additionally, workers may file lawsuits for benefits they were entitled to as employees, causing further financial and reputational damage to the company.

Best Practices for Classification

To ensure proper classification, follow these best practices:

  • Maintain clear contracts: Have detailed agreements outlining the nature of the relationship and responsibilities.
  • Review IRS guidelines: Regularly review the latest IRS guidelines and rulings on worker classification.
  • Consult professionals: Seek advice from tax professionals or legal experts when in doubt about classification.
  • Keep detailed records: Document the factors considered in classifying each worker to provide evidence if questioned by the IRS.

 

Conclusion

Proper classification of workers as employees or independent contractors is essential to avoid costly mistakes and ensure compliance with tax laws. By understanding the key factors and IRS guidelines, maintaining accurate records, and seeking professional advice, businesses can navigate the complexities of worker classification effectively. Always remember that the IRS closely scrutinizes these classifications, so careful consideration and proactive measures are crucial for compliance and financial health.