Independent Contractors vs. Employees
Are your workers independent contractors or employees? Always a confusing topic which is probably due to the fact that the IRS sets the rules. Nonetheless, the answer can have a profound impact on how much tax you pay as a small business owner.
Knowing whether your workers are or are not employees will affect the amount of taxes you must withhold from their pay. It will affect how much additional cost your business must bear, what documents and information they must provide to you, and what tax documents you must give to them. Employers who misclassify workers as independent contractors can end up with substantial tax bills as well as penalties for failing to pay employment taxes and failing to file required forms information.
Generally, whether a worker is an employee or an independent contractor depends upon how much control you have as a business owner. Basically, if you have the right to control or direct not only what is to be done but also how it is to be done then your workers are most likely employees. If you can direct or control only the result of the work done, and not the means and methods of accomplishing the result, then your workers are probably independent contractors.
Before you can determine how to treat payments you make for services, you must first know the business relationship that exists between you and the person performing the services. The person performing the services may be -
An independent contractor
A common-law employee
A statutory employee
A statutory nonemployee
In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.
In general, someone who performs services for you is your employee if you can control what will be done and how it will be done.
The courts have considered many facts in deciding whether a worker is an independent contractor or an employee based on these three categories:
1.) Behavioral Control – direct or control how the work is done. Facts that show whether the business has a right to direct and control. These include:
Instructions - an employee is generally told:
When, where, and how to work
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
What order or sequence to follow
Training – an employee may be trained to perform services in a particular manner.
2.) Financial Control – direct or control the financial/business aspects of the worker’s job. Facts that show whether the business has a right to control the business aspects of the worker’s job include:
· The extent to which the worker has unreimbursed expenses
· The extent of the worker’s investment
· The extent to which the worker makes services available to the relevant market
· How the business pays the worker
· The extent to which the worker can realize a profit or loss
3.) Type of Relationship – relates to how the workers and the business owner perceive their relationship. Facts that show the type of relationship include:
Written contracts describing the relationship the parties intended to create
Whether the worker is provided with employee-type benefits
The permanency of the relationship
How integral the services are to the principal activity
For a worker who is considered your employee, you are responsible for:
Withholding Federal income tax,
Withholding and paying the employer social security and Medicare tax,
Paying Federal unemployment tax (FUTA)
Issuing Form W-2, Wage and Tax Statement, annually,
Reporting wages on Form 941, Employer’s Quarterly Federal Tax Return.
Example of an Independent Contractor:
Vera Elm, an electrician, submitted a job estimate to a housing complex for electrical work at $16 per hour for 400 hours. She is to receive $1,280 every 2 weeks for the next 10 weeks. This is not considered payment by the hour. Even if she works more or less than 400 hours to complete the work, Vera Elm will receive $6,400. She also performs additional electrical installations under contracts with other companies, which she obtained through advertisements. Vera is an independent contractor.
How should I report payments made to independent contractors?
You may be required to file information returns to report certain types of payments made to independent contractors during the year. For example, you must file Form 1099-MISC, Miscellaneous Income, to report payments of $600 or more to persons not treated as employees (e.g. independent contractors) for services performed for your trade or business.
Who is a Common-Law Employee (Employee)?
Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.
To determine whether an individual is an employee or independent contractor under the common law, the relationship of the worker and the business must be examined. All evidence of control and independence must be considered. In an employee-independent contractor determination, all information that provides evidence of the degree of control and degree of independence must be considered.
Facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties.
Example of an employee:
Example: Donna Lee is a salesperson employed on a full-time basis by Bob Blue, an auto dealer. She works 6 days a week, and is on duty in Bob's showroom on certain assigned days and times. She appraises trade-ins, but her appraisals are subject to the sales manager's approval. Lists of prospective customers belong to the dealer. She has to develop leads and report results to the sales manager. Because of her experience, she requires only minimal assistance in closing and financing sales and in other phases of her work. She is paid a commission and is eligible for prizes and bonuses offered by Bob. Bob also pays the cost of health insurance and group-term life insurance for Donna. Donna is an employee of Bob Blue.
Statutory Employees
If workers are independent contractors under the common law rules, such workers may nevertheless be treated as employees by statute ( statutory employees ) for certain employment tax purposes if they fall within any one of the following four categories and meet the three conditions described under Social security and Medicare taxes , below.
A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.
A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.
An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done.
A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer s business operation. The work performed for you must be the salesperson s principal business activity. Refer to the Salesperson section located in Publication 15-A, Employer s Supplemental Tax Guide for additional information.
Statutory Nonemployees
There are two categories of statutory nonemployees: direct sellers and licensed real estate agents. They are treated as self-employed for all Federal tax purposes, including income and employment taxes, if:
Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked and
Their services are performed under a written contract providing that they will not be treated as employees for Federal tax purposes.
