Among tax compliance issues that often get overlooked, is the question of whether someone who works for you is an employee or a contractor. It’s the difference between someone being your employee or being self-employed. If handled incorrectly, there can be penalties for you as a business owner, as well as for the worker.
It is your responsibility as a business owner to understand if your worker is an employee or a contractor then follow the applicable tax rules for the classification you determine. Thankfully, there is specific guidance from the Internal Revenue Service (IRS) you can follow when making this classification.
Why does it matter?
Workers are treated differently for tax purposes by the IRS if they are an employee or a contractor. There is specific guidance provided by the IRS that we break down in more detail below, but here’s why the difference is important.
The main concern is a person’s eligibility for employee benefits like Social Security and Medicare taxes. If the person is a contractor or self-employed individual, it’s up to them to contribute to these benefits. If however, the person is an employee, it’s up to you, as the employer, to make sure these benefits are paid on the employee’s behalf.
Where businesses often get into trouble is they think they can save money by classifying all their workers as employee or a contractor and, therefore, not having to pay payroll benefits. The problem with this way of thinking is it goes against what the IRS states and can result in large penalties and interest for the business. For the employee, it means non-existent coverage when they need it.
The IRS Guidance About Employee or a Contractor
To keep your business onside, you must follow an employee or a contractor guidelines set out by the IRS to answer the employee vs contractor question. To help determine how you should classify a worker, the IRS considers three categories: behavioral control, financial control, and the relationship of the parties.
The key question here is: How much control do you have over how and when the work gets done? This is easier to determine in some professions than others, especially those with flexible work arrangements.
With regards to behavioral control, your worker is likely an employee if you:
- Determine when and how the work is carried out,
- Choose how and when the worker is paid,
- Decide the jobs the worker will do,
- Train the worker how to do the jobs.
- Work independently,
- Do not have anyone overseeing their activities,
- Can work when they want and for other people,
- Can accept and refuse work,
- Are not expected to continue the relationship (like an employee would be).
Financial control refers to who has the right to direct the financial and business aspects of the worker’s job. With regards to financial control, consider who is the most invested in the relationship. Who is taking on the financial risk or the ability to profit?
When looking at financial risk, your worker is an employee if they:
- Aren’t responsible for paying operating costs,
- Have a continuous relationship with you,
- Are not financially liable if the contract isn’t fulfilled,
- Have no say over how much and when you pay them.
With regards to financial risk, your worker is a contractor if they:
- Can hire help,
- Perform the work substantially from their own workspace,
- Are hired for a specific job rather than continuously,
- Could be financially liable if the contract is not fulfilled,
- Don’t receive any protection or benefits from you, such as payroll benefits or workers’ compensation coverage,
- Actively market their services.
When considering the opportunity for profit, your worker is an employee if they:
- Do not have the ability to realize a profit or loss,
- Are entitled to benefit plans generally only offered to employees such as group life insurance and extended health benefits.
Your worker is a contractor if they:
- Hire someone to help them,
- Are compensated by a flat fee and incur expenses in completing their work.
A final consideration when it comes to financial control is the investment in tools and equipment.
Your worker is most likely an employee if you:
- Supply the tools and equipment and are responsible for their upkeep,
- Retain the right of use of the tools and equipment,
- Reimburse the worker for the use of any of their own tools and equipment.
Your worker is most likely a contractor if they:
- Provide the tools and equipment needed to do the work and are responsible for their maintenance and upkeep,
- Have made a significant investment in the tools and equipment required for the job,
- Supply their own workspace and pay to maintain it.
When the IRS considers whether a worker is an employee or a contractor, they will look at how the two parties describe their relationship. How do they perceive their relationship with each other?
Without the existence of a well-written contract, and sometimes even when one exists, it can still be difficult to prove the nature of the relationship. There are a number of additional criteria the IRS looks at.
Key relationship items in determining whether a worker is an independent contractor or an employee include whether the worker is receiving benefits only employees can receive, whether the relationship is considered permanent, and whether the services performed by the worker are considered key activities of the business.
The IRS will examine all these factors on a case-by-case basis when looking at the employee or a contractor question. They try to get a well-rounded picture of the situation before determining employment status. It’s important you consider all these factors as well.
Inevitably, there are always challenges when it comes to staying on track with IRS compliance. If you feel your situation doesn’t fit neatly into the examples above or you’ve possibly misclassified a worker and need further guidance, contact us to learn more about how these rules apply to your unique situation.