Employee or Independent Contractor?
In order for a business owner to know how to treat payments made to workers for services, he or she must first
know the business relationship that exists between the
business and the person performing the services. A worker’s status determines what taxes are paid and who is responsible for reporting and paying those taxes.
A worker performing services for a business is generally an
employee or an independent contractor. If a worker is classified incorrectly, the IRS may assess penalties on the employer for nonpayment of certain taxes.
Penalties and Interest
When the IRS determines that a worker is actually an employee rather than an independent contractor, the employer is subject to penalties for failure to withhold and remit
income, FICA (Social Security and Medicare) and FUTA
(federal unemployment tax) taxes, interest on the underpaid amounts, and penalties for failure to file information
returns. The state will also seek to collect workers’ compensation and unemployment compensation premiums for
unreported wages.
Independent Contractor
An independent contractor is self-employed and is generally responsible for paying his or her own taxes through estimated tax payments. A business issues Form 1099-NEC,
Nonemployee Compensation, to any one independent contractor, subcontractor, freelancer, etc., to whom the business made $600 or more in payments over the course of the
tax year. The business is not generally responsible for withholding income tax or FICA.
Employee
A worker treated as an employee will be issued Form W-2,
Wage and Tax Statement, for wages paid. The business hiring the worker is responsible for withholding income tax
and FICA. The employer is also liable for FUTA and various
state employment taxes. Also, the employee may be eligible
for certain fringe benefits offered by the employer, such as
health care.
Factors to Determine Worker Status
The general rules for classifying workers as independent
contractors or common-law employees center on who has the right to control the
details of how services are to be performed. The factors can be grouped into
three categories.
1) Behavioral control. Factors
that indicate a business has the right to control a worker’s behavior include
the following.
• Instructions that the business gives to the
worker. Employers generally control when and where work is to be done,
what tools or equipment to use, what workers to hire or to assist with the
work, where to purchase supplies and services, what work must be performed by a
specified individual, and what order or sequence to follow.
• Training that the business gives to the worker. Employees
may be trained to perform a service in a particular manner. Independent
contractors generally use their own methods.
2) Financial control. Factors
that indicate a business has the right to control the business aspects of a
worker’s job include the following.
• Extent of the worker’s unreimbursed business
expenses. Independent contractors are more likely to incur expenses
that are not reimbursed, such as fixed overhead costs that the worker incurs
regardless of whether work is currently being performed.
• Extent of the worker’s investment. Independent
contractors often have significant investment in facilities used to perform
services for someone else, such as maintaining a separate office or other
business location.
• Extent to which the worker makes his or her
services available to the public. Independent contractors are generally
free to offer their services to other businesses or consumers. They often
advertise and maintain a visible business location.
• Method of payment for services performed. Employees
generally are guaranteed a regular wage and work for an hourly fee or a salary.
Independent contractors are generally paid a flat fee for a specific job.
Exceptions apply to some professions, such as accountants and lawyers who
charge hourly fees for their services.
• Extent to which the worker can make a profit. Independent
contractors can make a profit or a loss.
3) Type of relationship between the parties. Factors
that indicate the type of relationship include the following.
• Written contracts that describe
the relationship and intent between the worker and the business hiring the
worker.
• Employee-type benefits provided to worker.
Employers often provide fringe benefits to employees, such as health insurance,
pensions, and vacation pay.
• Permanency of the relationship. Employer-employee
relationships generally continue indefinitely.
• Extent services performed by the worker are a
key aspect of the business hiring the worker. A worker who is key
to the success of a business is more likely to be controlled by the business, which
indicates employee status. For example, an accounting firm hires an accountant
to provide accounting services for clients. It is more likely that the
accounting firm will present the accountant’s work as its own and would have
the right to control or direct that work.
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