The question of whether a worker is an independent contractor or employee for federal income and employment tax purposes is a complex one. There is a large body of law on the subject but ultimately the determination of a worker’s classification is a factual one. The stakes can be very high and wrongly classifying a worker can result in significant penalties and additional taxes.
A business that hires a worker as an employee must withhold the following from the employee’s pay: federal and state income taxes as well as the employee’s contribution to social security and Medicare (i.e., payroll taxes). Considering the employer share of payroll taxes are 7.345% of compensation (6.2% social security and 1.45% for Medicare) there is a significant financial advantage to classifying a worker as an independent contractor rather than an employee.
In addition to payroll taxes the employer must pay the employer’s share of the payroll taxes as well. Fringe benefits (such as participating in 401k plan and health insurance) are available only to employees. These obligations don’t apply for a worker who is an independent contractor. An independent contractor is not entitled to participate in the employer’s 401k plan or health insurance. Because employers do not contribute social security and Medicare taxes for independent contractors there is an incentive to classify workers as independent contractors.
Employees receive a W-2 from the employer each year which is used to prepare their individual tax return. Independent contractors are issued a Form 1099-MISC for the year showing what he or she was paid (if it amounts to $600 or more), and that’s it. Independent contractors are subject to self-employment taxes which means they pay both the employee’s and employer’s share of the payroll tax items.
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 and not what will be done and how it will be done. You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed.
The IRS has guidance on its website regarding classification of a worker as an independent contractor or employee:
Some individuals are considered employees for payroll tax purposes even if they aren’t subject to an employer’s direction and control (that is, even if the individuals wouldn’t be treated as employees). These employees are “statutory employees.” These individuals are agent drivers and commission drivers, life insurance salespeople, home workers, and full-time traveling or city salespeople who meet a number of tests. Statutory employees may or may not be employees for non-payroll tax purposes. Corporate officers are statutory employees for all purposes.
Individuals who are statutory independent contractors aren’t employees for purposes of wage withholding, or payroll tax purposes in general. These individuals are qualified real estate agents and certain direct sellers.
Some categories of individuals are subject to special rules because of their occupations. For example, corporate directors aren’t employees of a corporation in their capacity as directors, and partners of an enterprise organized as a partnership are treated as self-employed persons.
A potential disadvantage to treating workers as independent contractors concerns workers compensation. By definition workers compensation applies only to employees. Workers compensation is the remedy for injuries caused to employees during the course of their employment. As such the business is protected against liability for injuries or other damages caused to workers. An independent contractor is not limited to workers compensation for damages.
If a business wrongly classifies a worker as an independent contractor rather than an employee it is liable not only for the employer’s share of social security and Medicare (plus interest and possibly penalties) but it is also liable if the worker failed to pay their share of social security and Medicare taxes plus income taxes. Since an employer is required to withhold income taxes failure to withhold could create liability.
If you own a business, you should not take the classification of employees lightly. Unfortunately, many business owners are tempted by the upfront savings when they classify someone as an independent contractor instead of as an employee. But the tax penalties you may face as a result or wrongly classifying a worker can turn that short-term financial advantage into a long-term IRS nightmare.