By Eric J. Seidman, CPA
One of the most commonly asked questions by both employees and employers is how to classify certain work performed: by an employee or by independent contractor. The distinction is important because there are key tax and reporting ramifications. Further, if the correct distinction is not made, the employer could be in a world of hurt with amended returns and imposed penalties.
This blog offers a primer on the differences between employees and independent contractors, as well as various considerations for anyone asking this question.
The most important factor in determining if someone is an employee or contractor is the degree of control and independence in play. The IRS provides three rules related to control and independence:
- Behavioral: Can the company control what the worker does and how it's done?
- Financial: Are business aspects of the job controlled by the payer, such as how the worker is paid and whether expenses are reimbursed?
- Type of Relationship: Are there written contracts or employee benefits (vacation, insurance, pension plan, etc.)?
There is no bright-line test to make this determination. The totality of the circumstances must be weighed when making the distinction, which is important given the tax ramifications.
If a worker is an employee, he or she goes on payroll and has certain taxes withheld from pay (federal insurance contributions – FICA, federal and state unemployment tax, state and federal income tax withholding, etc.). The employer matches the FICA and pays state unemployment on a portion of the wages as well. For an employee earning $50,000, the payroll tax cost for the employer, assuming a 3.6% state unemployment tax rate, could be about $6,000. On top of that, an employer may take on health insurance for employees and other costs, such as a 401(k) match.
Some of these costs are not necessarily incurred by the employer if the relationship is deemed to be more of the independent contractor variety. Independent contractors are considered to be running their own business, and therefore would cover these costs on their own. Since contractors are paid via 1099s, no taxes are withheld or remitted by the employer. There is no company match for payroll taxes, as there is no reportable payroll. It's also unlikely that insurance or other benefits are provided to a contractor. Therefore, the independent contractor, considered to be self-employed, must pay FICA, Medicare, and state unemployment taxes as both the employee and employer. On the same $50,000 of income cited in the example above, the independent contractor may owe in the area of $9,000 to $10,000 in payroll taxes. This isn't a true apples-to-apples comparison, though, as the $50,000 to an independent contractor can be reduced by expenses incurred that an employee would not get to deduct on a tax return.
From an employer perspective, it is often more financially beneficial to categorize a worker as an independent contractor given the added costs. From a worker perspective, it could be more beneficial to be categorized as an independent contractor since unreimbursed expenses are fully deductible against income. With an employee classification, unreimbursed expenses used to qualify as a miscellaneous standard deduction when above the 2% adjusted gross income threshold, but this was eliminated as part of the Tax Cuts and Jobs Act of 2017. This is often where the crux of potential problems lies.
Regardless of the potential benefits for either side, the employer needs to carefully weigh all determining factors to avoid issues down the road. If the IRS were to challenge the worker classification and deem the worker to be an employee, the employer would owe back payroll taxes and incur possible penalties for misclassification. The standard relief provisions the IRS affords may not apply in this case.
A discussion of classification is an important one to have when a working relationship begins so both parties understand the implications. Consult your tax adviser if you are unsure about your classification with a company, or if you would like to gain further clarity on the tax and reporting ramifications for each.
Eric J. Seidman, CPA, is with Wouch, Maloney & Co. LLP in Horsham, Pa. He is a member of PICPA’s CPA Image Enhancement Committee and Greater Philadelphia Chapter Federal Taxation Committee.
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