Are You Self-Employed or an Employee?

[Originally posted September 2016]

Independent Contractor or Employee?

An area of IRS scrutiny for the past twenty years has been whether individuals working for a business are independent contractors or employees. Contrary to what many taxpayers believe, the classification is not a choice agreed to by the two parties but is governed by the type of relationship the business and the worker have. As a general rule, businesses would prefer to classify workers as independent contractors and the IRS would prefer to classify workers as employees.

Reporting and Tax Requirements for Independent Contractors

Amounts paid to independent contractors (ICs) are not subject to withholding and they are not eligible to receive employee benefits like health insurance and retirement contributions. The IC is required to report and pay self-employment tax on amounts. If you pay an IC $600 or more during the year you have a requirement to report those payments on Form 1099. When you hire an independent contractor (even if you believe they will earn less than $600) you need to have them complete Form W-9 (here) which will give you the information you need to file Form 1099 at the end of the year. In some cases you do not need to complete a Form 1099 and the Form W-9 will give you the information you need to make that determination each year. If you hire ICs you generally do not have any State reporting requirements. If you decide to discontinue your relationship with an independent contractor, your relationship simply ends.

Reporting and Tax Requirements for Employees (EEs)

Amounts paid to employees (EEs) are subject to social security, medicare, and income tax withholding no matter how small the amount paid. Having EEs significantly increases your tax reporting burden. Your employee pays only one-half of their social security and medicare tax and therefore, the amount you are actually paying them per hour is more than their hourly rate. In addition to reporting and paying payroll taxes, EEs are also eligible for employee benefits. If you are a sole-proprietor and then hire EEs you may be required to include the employees in your retirement and health insurance plans. Wages are reported on Form W-2 regardless of the amount. If you hire EEs you are required to have them complete both Form  i-9 (here) to determine employment eligibility and Form W-4 (here) to determine how much to withhold for income taxes. If you hire employees you will have State reporting requirements in addition to the Federal reporting requirements. If you fire an EE or if an EE is injured on the job, you will have unemployment and/or workman’s compensation claims to deal with.

Factors IRS looks at in determining Classification

As mentioned above, you can’t just decide whether a worker is an IC or a EE, it depends on the facts. You can, however, structure your relationships so that they are more likely to qualify as one classification. In the past, the IRS had a 20 question form which you could complete to help you determine whether a worker was an IC or an EE but the IRS has abandoned this checklist in favor of the guidelines that look at the relationship between the business and the worker and the amount of behavioral and financial control the business has over the worker.

The IRS describes behavioral control as follows:

Behavioral Control covers facts that show if the business has a right to direct and control what work is accomplished and how the work is done, through instructions, training, or other means.

The IRS describes financial control as follows:

Financial Control covers facts that show if the business has a right to direct or control the financial and business aspects of the worker’s job. This includes:

    The extent to which the worker has unreimbursed business expenses

    The extent of the worker’s investment in the facilities or tools used in performing services

    The extent to which the worker makes his or her services available to the relevant market

    How the business pays the worker, and

    The extent to which the worker can realize a profit or incur a loss

Finally, the IRS looks at the relationship between the parties as follows:

Relationship of the Parties covers facts that show the type of relationship the parties had. This includes:

    Written contracts describing the relationship the parties intended to create

    Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay

    The permanency of the relationship, and

    The extent to which services performed by the worker are a key aspect of the regular business of the company

The IRS will look at the overall relationship between the business and the worker. So, if you have a contract with the worker that states the relationship is IC but you set hours for the worker, you pay their health benefits, you provide their tools, you are the only business that hires the worker, then it is likely that the relationship is EE, not IC.

Consequences of Misclassification

The costs associated with misclassifying an individual as a IC when they are actually an EE can be significant. If you are found to be incorrectly reporting as IC amounts paid to an EE, you will, at a minimum, be subject to paying payroll taxes on past amounts plus penalties and interest. In addition, if you provide employee benefits like health insurance and retirement you may have to pay and/or make up contributions to these benefit plans. Even worse, you may have a disqualified retirement plan since you were not included all of the eligible employees. It can get ugly.

Although you might think it unlikely that you would be selected for audit, this can’t support your choice to treat individuals as independent contractors nor is it a safe assumption. It is much more likely that a disgruntled IC will notify the IRS that they are being treated as an IC rather than an employee that will start an investigation into your reporting than a random IRS audit. As your business grows you will eventually have to hire employees. Despite the additional reporting and cost of employees, in the long run the right decision is to properly report employees as employees and independent contractors as independent contractors.