Independent Contractor or Employee? Using IRS Guidelines
It’s important businesses correctly classify the individuals working with them as employees or independent contractors. Typically, employers must withhold income taxes, withhold and pay social security and Medicare taxes, and pay unemployment tax on wages paid to an employee. Independent contractors, on the other hand, usually don’t have taxes withheld and pay all their own taxes. Misclassification of an individual can result in fines, penalties, and payment of back taxes as well as owed minimum wage or overtime payments for any individuals determined to be employees. To assist businesses with making this classification correctly for tax purposes, the IRS has developed the “Independent Contractor (Self-Employed) or Employee” resource. Here is a closer look at what businesses need to know.
Determining the Relationship
The first step businesses need to complete is determining their relationship with the person completing the services. The IRS lists four options:
- Independent Contractors
- Employees (Common-Law Employee)
- Statutory Employees
- Statutory Nonemployees
The categories most often in question are independent contractor vs. employee (common law employee). The IRS provides detailed guidelines for both statutory employees and statutory nonemployees online as well.
Factors Used to Classify Workforce Relationships
The IRS used to use a “20 factor test” to determine whether an individual was an employee or independent contractor. Today, it takes a different approach. The IRS instructs businesses to consider three categories of “facts that provide evidence of the degree of control and independence” in the relationship. The three categories are:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does their job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (These include things like how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Type of Relationship: Are there written contracts or employee-type benefits (i.e., pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?”
Making Individual Determinations
Often, business owners find it challenging to evaluate these broad categories of control and influence effectively. Further breakdowns of each of the three categories above are provided to help ask the right questions and consider the essential factors. These breakdowns are available here: Behavioral Control, Financial Control, and Type of Relationship.
Each of the categories offers specific aspects to consider. For example, behavioral control can include whether the individual is given detailed instructions, whether they are required to provide services personally, and what kind of reports they give their contact at your company. Financial questions address how and when the individual is paid, whether expenses are reimbursed, and who provides any necessary tools or equipment. In terms of the type of relationship, the guide outlines specific factors such as whether the individual is working for more than one firm at a time and whether the individual makes services available to the general public.
For firms that have evaluated the three categories of evidence and are still struggling to make an accurate classification, there are a number of choices available. One option is to file Form SS-8, answer a detailed questionnaire and submit it to the IRS. The IRS website notes that it may take up to six months to receive a determination. Another strategy is to partner with an experienced HR service provider who can consult on your case and offer guidance and resources so you can better determine which classification is right for your unique situation. You may also wish to discuss your situation with legal counsel.