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An employer must generally withhold federal income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment taxes on wages paid to employees. In general, the requirement to withhold and pay taxes does not apply to payments made to bona fide independent contractors.
For tax withholding and payment purposes, the Internal Revenue Service (IRS) uses a Common Law test to determine whether a worker is an independent contractor or an employee. The test examines factors related to behavioral control, financial control, and the type of relationship between the business and the worker.
All factors must be weighed when determining whether an individual is an employee or independent contractor. There is no set number of factors that must be met, and no one factor stands alone in making this determination.
Factor 1: Behavioral Control
A worker is an employee when the business has the right to direct and control the worker, including:
- When and where to do the work
- What tools or equipment to use
- What workers to hire or to assist with the work
- Where to purchase supplies and services
- What order or sequence to follow
- What training to complete
- How the work results are achieved
Factor 2: Financial Control
A worker is an employee when the business has the right to direct or control the financial and business aspects of the worker’s job. This factor examines:
- Unreimbursed business expenses: As compared with employees, independent contractors are more likely to have unreimbursed expenses, or fixed ongoing costs that are incurred regardless of whether work is currently being performed. Independent contractors are also more likely to realize a profit or incur a loss.
- Investment in facilities or tools: An independent contractor often has a significant investment in the facilities or tools he or she uses in performing services for someone else.
- Services available to the relevant market: Independent contractors often advertise, maintain a visible business location, and are available to work for other businesses in the relevant market. Employees, on the other hand, generally work for one company at a time.
- How the worker is paid: An employee is generally guaranteed a regular rate of pay per hour or pay period. An independent contractor is often paid a flat fee or on a time and materials basis.
Factor 3: Type of Relationship
This factor examines whether:
- There is a written contract describing the relationship the parties intended to create.
- The business provides the worker with employee-type benefits, such as health insurance or paid time off.
- An employer engages a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period. This is generally considered evidence of an employer-employee relationship.
- The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of the company’s regular business, it is more likely that the company will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work.
IRS Independent Contractor Determination:
Employers seeking assistance from the IRS in making an independent contractor determination can file Form SS-8: Employee Status Determination. The IRS will review the facts and circumstances and officially determine the worker’s status. Ordinarily, this process takes at least six months. If you are unsure whether a worker qualifies as an independent contractor, err on the side of caution and classify the individual as an employee.
To determine whether an employment relationship exists, and whether the employer is required to provide unemployment insurance coverage to an individual, many states use what is known as the “ABC” test. An employment relationship exists (and unemployment insurance coverage is required) unless and until the employer is able to demonstrate that all three parts of the ABC test are met:
- The individual has been and will continue to be free from control or direction over the performance of services, both under his or her contract of service and in fact and
- Such service is either outside the usual course of the business or such service is performed outside of all business locations and
- The individual is customarily engaged in an independently established trade, occupation, profession or business.
Check your state law to ensure compliance
An employer’s administrative responsibilities related to independent contractors differ from those required for an employee. Here are some general requirements:
- Employers must issue IRS Form 1099 for income reporting (see below), instead of Form W-2 (issued to employees), to employees and transmit the forms to the IRS.
- Employers must use Form 1096 to transmit paper 1099s to the IRS.
- Independent contractors are not subject to state and federal income tax withholding and employers are not required to make FICA contributions on behalf of independent contractors.
- Independent contractors are not entitled to traditional benefits offered to employees, including health insurance, stock options, retirement plans, and paid time off.
- Employers are not required to pay premiums for workers’ compensation or unemployment insurance for an independent contractor.
- Employers should ensure that independent contractors carry their own insurance.
Businesses that pay $600 or more to an independent contractor in a tax year must supply a completed Form 1099-MISC to both the independent contractor and the Internal Revenue Service. On the form, use box 7 to enter the independent contractor’s total compensation.
The fines and penalties for misclassifying an employee as an independent contractor vary by state. For example, some states (such as Pennsylvania and Colorado) have imposed criminal penalties for employers that intentionally misclassify a worker as an independent contractor.
In general, if it’s been determined that an employee has been incorrectly classified as an independent contractor, he or she may be awarded back pay, overtime and benefits. In addition, the employer may be ordered to pay back taxes, interest, and fines.
Given increased government focus on employee misclassification, including an increase in the number of audits conducted by the Internal Revenue Service (IRS) and other government agencies, it’s extremely important for employers to ensure all workers are classified correctly.