Site Sponsor
Tax
& Information Filings
Employee vs. Contractor
Employee vs. Contractor
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.
It is critical that you, the employer, correctly determine whether the individuals providing services are employees or independent contractors. Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors.
Caution: If you incorrectly classify an employee as an independent contractor, you can be held liable for employment taxes for that worker, plus a penalty.
Who is an Independent Contractor?
A general rule is that you, the payer, have the right to control or direct only the result of the work done by an independent contractor, and not the means and methods of accomplishing the result.
Example: 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, that 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. For details about filing Form 1099 and for information about required electronic or magnetic media filing, refer to information returns.
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. Refer to Publication 15-A, Employer's Supplemental Tax Guide for additional information.
Who is an Employee?
A general rule is that anyone who performs services for you is your employee if you can control what will be done and how it will be done.
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.
Refer to information on Direct Sellers located in Publication 15-A, Employer's Supplemental Tax Guide for additional information.
Misclassification of Employees
Consequences of treating an employee as an independent contractor. If you classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker. See Internal Revenue Code section 3509 for additional information.
Payroll Taxes -- A Hot IRS Initiative -- With a Burning Question: Employee or Independent Contractor
The IRS will be selecting 500 nonprofit organizations for payroll audits in each of the next three years (as well as a high number of for-profit companies). This is an area the IRS believes it can collect a lot of unpaid taxes, interest, and penalties. Obviously, timely and accurate filings of payroll tax returns will be checked as well as up-to-date payroll and W-9 files. However, the biggest issue with the IRS will be proper classification of employee vs. independent contractor. It is tempting to classify a worker as a contractor in order to save payroll taxes and to avoid withholding of federal and state taxes, but without a firm basis for doing so, the penalties can be severe. Thus, it is an excellent time for organizations to assure themselves that their payroll houses are in order. In addition to being sure that files are in order and the payroll tax returns match the accounting records, a checkup on the rationale for any worker classified as independent contractor is an excellent idea. The organization may choose to do this internally or hire an outside consultant with expertise in this area. The IRS will apply a “facts and circumstances” approach to determine if an individual working for an organization is an employee or an independent contractor. The IRS bases its determination on control by the organization and degree of independence of the contractor. It looks at three categories in this regard: behavioral control, financial control, and the type of relationship between the parties. To assist with this analysis, the following list of questions may be helpful:
- How much control/instruction is provided by the organization? Significant day-to-day control is indicative of employee status.
- Can the contractor send in another person or staff to do the work? If so, contractor status is more likely.
- Is this a continuing relationship? If the same work is done over a long period of time by the same person, employee status is more likely.
- Is the person paid by the task or by the hour, week, or month? If by the task, contractor status is more likely.
- Is the work done in the organization’s office or elsewhere? If done in the office, the IRS will lean toward employee status.
- Who pays the person’s expenses and provides the needed tools or equipment for the work? If paid by the organization, employee status is more likely.
- Does the person have several different clients vs. only working for the organization? Having several different clients is favorable toward contractor status.
- Can the person easily be terminated or easily quit? If so, employee status is more likely.
None of these factors is the only determinant (read the IRS guidance for additional factors and examples), but rather, each should be considered as a building block for having a strong position one way or the other. Just having a contract with an individual (although highly recommended) that identifies the person as an independent contractor is not a guarantee the IRS will agree with the status—the facts and circumstances must back up that status. The IRS Website, http://www.IRS.gov, has a virtual course in its “Charities and Nonprofits” tab which provides a lot of information on this topic. Additionally, IRS Circular E ,which can be downloaded from the website at http://www.irs.gov/publications/p15/index.html, contains a significant amount of detail on this topic. As with most IRS initiatives, it is always better to be ready prior to an IRS inquiry. To ensure compliance with Treasury Department regulations, we wish to inform you that any tax advice that may be contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties under the Internal Revenue Code or applicable state or local tax law provisions or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. Material discussed in this tax alert is meant to provide general information and should not be acted on without professional advice tailored to your organization’s individual needs.
Related
Payroll Taxes -- A Hot IRS Initiative -- With a Burning Question: Employee or Independent Contractor
The IRS will be selecting 500 nonprofit organizations for payroll audits in each of the next three years (as well as a high number of for-profit companies). This is an area the IRS believes it can collect a lot of unpaid taxes, interest, and penalties. Obviously, timely and accurate filings of payroll tax returns will be checked as well as up-to-date payroll and W-9 files. However, the biggest issue with the IRS will be proper classification of employee vs. independent contractor.