By Guest Blogger Nancy Montanye, CPA
When tax forms go out in January, company employees receive W-2 forms; those who are independent contractors received 1099s. Throughout the year, employees receive paychecks with taxes withheld. Independent contractors are self-employed workers who receive gross income payments, without any tax deducted. Employers must not only withhold taxes for employees, but also pay Social Security, Medicare, and unemployment taxes on wages paid to employees. Independent contractors are responsible for paying all their own taxes.
So, what is the difference between an employee and an independent contractor? What are the rules? This can be surprisingly complicated. Below are the common-law rules for employees. However, there are statutory exceptions to these rules – mostly in the sales and direct customer service arenas – which are beyond the scope of this article. See IRS Publication 15-A for more information.
Businesses must determine whether individuals providing services to them are employees or self-employed independent contractors. The IRS has established guidelines to help with worker classification issues. It is important to be in compliance to minimize exposure to stiff fines and penalties. The key factor in the determination is how much control the business has over the worker. More control means the worker is likely an employee; less control means the worker may be an independent contractor. Multiple questions are asked to reach the proper conclusion. The type of control and independence falls into three categories: behavioral control, financial control, and the relationship.
Behavioral control generally indicates employee status when it addresses such issues as the right to direct how a worker does the work, when and where to do the work, what tools or equipment to use, what workers to hire to assist with the work, where to purchase supplies, and what sequence to follow when doing the work. Also, an evaluation system that measures the details of the work performed and training provided on how to do the job would both point to an employee classification.
Financial control indicates whether the business has given control of economic aspects of the job to the worker, which therefore would make them more in line with an independent contractor. If the worker has significant investment in the tools and equipment used in working for someone else, this may be an independent contractor. However, in some industries (such as construction), large expenditures alone do not indicate an independent contractor relationship. Also, independent contractors are more likely to have unreimbursed expenses. The independent contractor has the opportunity to incur a loss, and offers similar services to others. Employees generally get a regular wage (or commission); an independent contractor is often paid a fee for a job.
The relationship refers to the facts as viewed between the worker and the business. A written contract that states a worker’s status is not enough for the IRS; the determining factors are the working relationship. Employee benefits, such as insurance, paid vacation, sick days, and pension plans, are generally only available to employees. If the relationship will continue indefinitely, rather than for a specific project, then it is likely an employee relationship. If the services are for a key activity of the business, it is more likely that there will be a right to control, which would indicate an employee relationship.
Multiple factors must be considered before determining whether someone is properly identified as an employee or an independent contractor. The facts must be considered as a whole, which can be complex. Professional advice is recommended when in doubt. The IRS had stepped up its enforcement in this area, tending to favor the employee classification. It is important, then, that whichever worker classification is chosen, that it be determined thoughtfully, appropriately, and consistently.
To request that the IRS make a decision on the classification issue, IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, can be filed by either party – the worker or the business. This process can take at least six months to get a determination. In addition, the IRS has a Voluntary Classification Settlement Program (VCSP) available for taxpayers to reclassify their workers as employees for employment tax purposes for future tax periods with partial relief from federal employment taxes. Certain eligibility requirements must be met. IRS Form 8952, Application for Voluntary Classification Settlement Program, must be completed, and a closing agreement must be entered with the IRS.
In any complicated or unclear situation regarding worker classification issues it is best to seek professional advice prior to making any payments or coming to terms on any contracts or agreements. This way, problems are reduced while assuring compliance with the rules.
Nancy G. Montanye, CPA, is a sole practitioner in Williamsport, Pa. She is a certified financial planner and a certified specialist in estate planning, whose specialties include gas leases and royalties, estates and trusts, and taxation. She is a PICPA member and serves on the Natural Gas Committee and the CPA Image Enhancement Committee.