Many businesses use independent contractors to help keep their costs down — especially in these times of staff shortages and inflationary pressures. If you’re among them, be careful that these workers are properly classified for federal tax purposes. If the IRS reclassifies them as employees, it can be an expensive mistake.
The question of whether a worker is an independent contractor or an employee for federal income and employment tax purposes is a complex one. If a worker is an employee, your company must withhold federal income and payroll taxes and pay the employer’s share of FICA taxes on the wages, plus FUTA tax. A business may also provide the worker with fringe benefits if it makes them available to other employees. In addition, there may be state tax obligations.
On the other hand, 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).
No One Definition
Who’s an “employee?” Unfortunately, there’s no uniform definition of the term.
The IRS and courts have generally ruled that individuals are employees if the organization they work for has the right to control and direct them in the jobs they’re performing. Otherwise, the individuals are generally independent contractors. But other factors are also taken into account including who provides tools and who pays expenses.
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.
Note: Section 530 doesn’t apply to certain types of workers.
You Can Ask The IRS But Think Twice
Be aware that 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.
Businesses should consult with us before filing Form SS-8 because it 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 who want an official determination of their status can also file Form SS-8. Dissatisfied 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. It identifies the worker and includes a blank Form SS-8. The business is asked to complete and return the form to the IRS, which will render a classification decision.
How do I determine if someone is an employee or an independent contractor?
There is no uniform definition of the term “employee,” but the IRS and courts have generally ruled that individuals are employees if the organization they work for has the right to control and direct them in the jobs they’re performing. Various other factors, including the worker’s level of autonomy and independence and the nature of the work being performed, are also considered. The IRS provides guidance on this issue, including a set of criteria known as the “Common Law Rules,” which help employers determine whether a worker is an employee or an independent contractor.
What is the risk of asking the IRS (on Form SS-8) to rule on whether a worker is an independent contractor or employee?
Asking the IRS to rule on worker classification may trigger an audit and potential tax liabilities for the employer. The IRS may also require back payment of employment taxes, penalties, and interest. The IRS has a history of classifying workers as employees rather than independent contractors. Businesses should consult with us before filing Form SS-8 to avoid these issues.
What are some tax-related differences between employees and independent contractors?
There are several tax-related differences between employees and independent contractors. For example, businesses are obligated to withhold taxes from employees’ paychecks. For independent contractors, businesses are only required to issue form 1099-NEC (if compensation for the year was $600 or more) and are not obligated to withhold taxes.
These are the basic tax rules. Contact us if you’d like to discuss how to classify workers at your business. We can help make sure that your workers are properly classified.