Employee or Independent Contractor?
By Kristi Vaughan
In an effort to minimize ongoing expenses, many small businesses keep payroll expenses low by hiring workers as independent contractors or freelancers. After all, why worry about benefits, withholding, Medicare, Social Security or unemployment taxes if you don't have to? But wait just a minute . unless you are carefully following federal tax rules on employee status, you could unknowingly be opening yourself up to employment tax liabilities and penalties.
Types of workers
The federal Internal Revenue Service identifies four classifications of people who might perform services for your business:
- Independent contractor
- Employee
- Statutory employee
- Statutory non-employee
Independent contractor vs. employee
A major difference between independent contractors and employees is the degree of control that you, as the payer, have over their work.
Generally speaking, the IRS agrees that someone is an independent contractor if you can control only the result of the work, not the means or method.
A person is considered your employee if you control what will be done and how it will be done.
Another major determinant is whether the worker also performs similar services for other businesses or clients.
Questions to help you decide
Answering yes to any of the following is an indication that you should look more closely at whether the worker truly meets the criteria of independent contractor.
Do you control:
- When and where the work is done?
- What tools or equipment to use?
- What workers to hire to assist with the work?
- Where to purchase supplies and services?
- Which individual does specific tasks?
- In what sequence the work must be performed?
Also,
- Do you reimburse expenses?
- Is the worker restricted from seeking other business opportunities?
- Is the worker guaranteed a certain wage amount?
- Do you and the worker expect the relationship to continue indefinitely?
- Are these services a key aspect of your regular business activity?
If you have answered yes to any of these questions, you should discuss the worker's status with your tax professional. Additionally, the IRS also offers information in the article Employees vs. Independent Contractors.
Statutory employees and statutory nonemployees
To further complicate matters, some independent contracts can be considered statutory employees for purposes of Medicare and Social Security tax. Under certain circumstances, these can include drivers who distribute beverage and food products who are paid as your agent or on commission; life insurance sales agents; people who work for you from their home and certain salespeople. Your tax professional can help you determine the correct status of such workers.
Statutory nonemployees include direct sellers and licensed real estate agents who receive most of their payment as the result of sales rather than number of hours worked and who have signed contracts saying they will not be treated as employees for federal tax purposes.
Consequences of misclassification
If the IRS disagrees with the classification you have given your workers, you can be held liable for relevant employment taxes. Additionally, a penalty could be invoked. Employers generally pay Social Security and Medicare taxes on behalf of employees as well as certain employment taxes.