Correctly classifying a worker is an important decision. Classified as an employee, the business will need to withhold the appropriate income, Social Security, Medicare and unemployment taxes. It is not normally necessary to withhold or pay taxes on payments to Independent Contractors who are generally subject to self-employment tax.
According to the Internal Revenue Service (IRS), “an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done or how it will be done.” As a business owner, you need to consider the amount of control the employer has and the degree of independence the worker has in a relationship. Every situation must be looked at individually. The IRS urges business owners to consider three categories when it comes to classifying a worker: Behavioral Control, Financial Control, and the Relationship of the Parties.
Behavioral Control encompasses the type and degree of instruction provided, training and evaluation. Financial Control refers to such things as who has invested in equipment or supplies, who is at risk for financial gain or loss, and the method of payment used. And finally, Relationship involves contracts, benefits, permanency and the primacy of the work or services as part of the business.
The consequences of misclassifying an employee without a reasonable basis leave employers subject to employment taxes. And misclassifying employees as contractors carries higher penalties than misclassifying an independent contractor as an employee. Whether the misclassification is an intentional attempt to avoid taxes or not, back taxes and penalties for income, Social Security, Medicare, and unemployment taxes, will likely be involved.
As independent contractors and self-employment trends grow, the distinctions are not always black and white. There is no single qualifying question that can determine how to classify a worker. To help you navigate this grey area, we have created a questionnaire based upon the IRS.gov categories. Once you have answered these questions, you can see which side most of your answers fall on and that can help you make your choice. If you find you have inadvertently misclassified an Employee as an independent contractor, the IRS has a Voluntary Classification Settlement Program (VCSP) that offers certain eligible businesses the option to reclassify their workers as employees with partial relief from federal employment taxes. More resources can be found at IRS.gov and your accountant can provide additional guidance and direction.
Correctly classifying your workers will give you peace of mind and help you avoid problems down the road.
This article and the accompanying questionnaire are for information purposes only and do not constitute tax advice.