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It is very important that small business understand and correctly apply the rules for classifying a worker as an employee or an independent contractor. For federal employment tax purposes, a business must examine the relationship between itself and the worker.
Worker Classification is important because it determines if an employer must withhold income taxes and pay Social Security, Medicare taxes and unemployment tax on wages paid to an employee. Businesses normally do not have to withhold or pay any taxes on payments to independent contractors. The earnings of a person working as an independent contractor are subject to self-employment tax.
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, not what will be done and how it will be done. Small businesses should consider all evidence of the degree of control and independence in the employer/worker relationship. Whether a workers is an independent contractor or employee depends on the facts and circumstances in each situation.
To better determine how to properly classify a worker, consider these three categories – Behavioral Control, Financial Control and Relationship of the Parties.
Behavioral Control: A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. Behavioral control categories are:
Financial Control: Does the business have a right to direct or control the financial and business aspects of the worker's job? Consider:
Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. This includes:
Classifying an employee as an independent contractor with no reasonable basis for doing so makes employers liable for employment taxes. Certain employers that can provide a reasonable basis for not treating a worker as an employee may have the opportunity to avoid paying employment taxes. See Publication 1976, Section 530, Employment Tax Relief Requirements for more information.
In addition, the Voluntary Classification Settlement Program, offers certain eligible businesses the option to reclassify their workers as employees with partial relief from federal employment taxes.
Use Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding to help determine the status of a worker. IRS Publication 15-A, Employer's Supplemental Tax Guide, is also an excellent resource.
Workers who believe an employer improperly classified them as independent contractors can use Form 8919 to figure and report the employee’s share of uncollected Social Security and Medicare taxes due on their compensation.
A worker does not have to meet all 20 criteria to qualify as an employee or independent contractor, and no single factor is decisive in determining a worker's status. The individual circumstances of each case determine the weight IRS assigns different factors.
Employers uncertain about how to classify a worker can request an IRS determination by filing Form SS-8, “Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” Some tax specialists caution that IRS usually classifies workers as employees whenever their status is not clear and, employers that request an IRS determination lose certain protections against liability for misclassification.
If the company directs when, where, and how work is done, this control indicates a possible employment relationship.
Requesting workers to undergo company-provided training suggests an employment relationship since the company is directing the methods by which work is accomplished.
Workers whose services are integrated into business operations or significantly affect business success are likely to be considered employees.
Companies that insist on a particular person performing the work assert a degree of control that suggests an employment relationship. In contrast, independent contractors typically are free to assign work to anyone.
If a company hires, supervises, and pays a worker's assistants, this control indicates a possible employment relationship. If the worker retains control over hiring, supervising, and paying helpers, this arrangement suggests an independent contractor relationship.
A continuous relationship between a company and a worker indicates a possible employment relationship. However, an independent contractor arrangement can involve an ongoing relationship for multiple, sequential projects.
People whose hours or days of work are dictated by a company are apt to qualify as its employees.
Full-time work gives a company control over most of a person's time, which supports a finding of an employment relationship.
Requiring someone to work on company premises— particularly if the work can be performed elsewhere—indicates a possible employment relationship.
If a company requires work to be performed in specific order or sequence, this control suggests an employment relationship.
If a worker regularly must provide written or oral reports on the status of a project, this arrangement indicates a possible employment relationship.
Hourly, weekly, or monthly pay schedules are characteristic of employment relationships, unless the payments simply are a convenient way of distributing a lump-sum fee. Payment on commission or project completion is more characteristic of independent contractor relationships.
Independent contractors typically bear the cost of travel or business expenses, and most contractors set their fees high enough to cover these costs. Direct reimbursement of travel and other business costs by a company suggests an employment relationship.
Workers who perform most of their work using company-provided equipment, tools, and materials are more likely to be considered employees. Work largely done using independently obtained supplies or tools supports an independent contractor finding.
Independent contractors typically invest in and maintain their own work facilities. In contrast, most employees rely on their employer to provide work facilities.
Workers who receive predetermined earnings and have little chance to realize significant profit or loss through their work generally are employees.
People who simultaneously provide services for several unrelated companies are likely to qualify as independent contractors.
If a worker regularly makes services available to the general public, this supports an independent contractor determination.
A company's unilateral right to discharge a worker suggests an employment relationship. In contrast, a company's ability to terminate independent contractor relationships generally depends on contract terms.
Most employees unilaterally can terminate their work for a company without liability. Independent contractors cannot terminate services without liability, except as allowed under their contracts.
The IRS considers a worker to be your employee if you have the right to control not only what work will be done, but also how the worker will do it. If you treat a worker as an independent contractor, but the IRS decides you have sufficient control over the worker to create an employment relationship, the IRS can hit you with a costly bill for the employment taxes you should have been withholding and paying.