This article’s aim is to help you make an informed decision and avoid the potential consequences of misclassification.
It’s usually easy to classify a worker as your employee or an independent contractor. But sometimes the decision is difficult and might go either way.
For the IRS, the difference between employees and independent contractors is a matter of “classification.” If the person you hire is not classified correctly, the IRS views that as a matter of “misclassification.”
Intentional misclassification of an employee as a contractor, or vice versa, is a crime that can have serious legal and financial consequences.
It’s important to know the difference between contractors and employees so your business can stay compliant with important tax and employment laws.
The way a business pays and withholds taxes differs for employees and contractors. The difference can have a substantial effect on a company’s finances.
For employees, an employer must:
Then, at the end of the tax year, employers must send a completed W-2 form to all employees so they can complete their personal tax filing.
Generally, companies need not withhold taxes for their independent contractors. This is because the vast majority of contractors operate as self-employed workers and pay all of their income and FICA taxes themselves.
When hiring a contractor, you simply ask them to fill out an IRS W-9 Form. Then, at the end of the tax year, you send IRS Form 1099 to the contractor and the government.
Because costs of payroll services and tax obligations are more with employees than with contractors, some businesses are tempted to misclassify employees as contractors.
If the IRS discovers a company has done this, and if it disagrees with the company’s classification decision, not only may the company be liable for back taxes, but the company could also face severe penalties, depending on whether the misclassification was a mistake or intentional.
Also, if one of your contractors fails to pay required taxes, the IRS may come to you for the amounts owed, claiming the contractor was really an employee.
It’s therefore critical for a business owner to correctly determine and document whether those who provide services for the business are contractors or employees.
Here are important factors to consider when classifying contractors and employees:
According to the IRS, an independent contractor is someone you hire to perform work and you control only the result of the work and not how it will be done.
Most contractors are working professionals who own and operate their own business to perform tasks for other businesses. Consultants, accountants, website developers, carpenters, custodians and other professional service providers are common examples of contractors. They:
For the IRS, an employee is anyone who performs services for you when you control the details of how they do their work.
Employees are compensated with hourly wages, an annual or monthly salary, commissions, other benefits, or a combination of the above, and you:
In close cases, there are several things to consider when classifying someone as an independent contractor or employee. Here are questions to ask yourself:
The first and most important factor determining whether a person is an employee or a contractor is behavioral control. When it comes to employees, the employer has significant control over how a particular job is done. For example, an employer may:
These and other similar factors almost always demonstrate an employer-employee relationship.
But a contractor will typically;
The next factor is financial control. When hiring an employee, the employer has all control over how the employee is compensated; the employer can freely give raises or bonuses, or even make pay cuts if the worker doesn’t perform.
With a contractor, however, financial compensation is usually arranged by contract on a per project basis. It’s common for multiple contractors to bid for a project, and then the paying company selects which contractor to hire. Once terms are set, both sides must abide by a contract between them.
In this way, contractors control their own compensation by limiting their hours and expenses to only those necessary to complete the project consistent with the contract.
For the IRS, some things always suggest an employer-employee relationship – avoid these as best you can when working with contractors:
There are many ways to avoid the risks of worker misclassification; here are three:
Record why you made a worker classification. This will not only help you make a reasonable choice, but also help you defend your decision if the IRS challenges it.
Most hiring decisions are straightforward and do not require extensive documentation. But keeping a written record of classification factors – especially when you believe the decision may be borderline – could be especially helpful.
If you do classify a worker as a contractor, collect from them copies of documentation, such as:
A written agreement with your service provider will typically outline the factors used to classify him or her as a contractor or an employee. If the IRS challenges your classification of an employee as a contractor, your written agreement with the service provider will be the first thing asked for.
Unfortunately, the distinction between independent contractors and employees is not always clear; there is no “magic” formula to making the worker an employee or an independent contractor. In close cases, several factors come into play, and no one factor stands alone in making the determination.
Use care when classifying your workers. Seek guidance – from the IRS, your certified public accountant and a lawyer – when in doubt.
I hope this short summary helps you better understand the current employer landscape regarding contractors vs. employees.–Robert A. Youngberg
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