How to Classify Worker as Independent Contractor or Employee

By | December 21, 2014

The question of whether a worker is an independent contractor or employee for federal income and employment tax purposes is a complex one. However, it is essential that employers get the determination correct or they can be subject to large penalties and other IRS problems.

How to Classify Worker as Independent Contractor or Employee

For example, if a worker is considered an employee under federal tax law, the company must withhold federal income and payroll taxes, pay the employer’s share of FICA taxes on the wages plus FUTA tax, and often provide the worker with fringe benefits it makes available to other employees. There may be state tax obligations in addition to paying federal employment taxes.


Independent Contractor or Employee for Tax Purposes

On the other side of the spectrum, if the employee is considered an independent contractor, none of these tax reporting issues will be problematic. The business sends the independent contractor aForm 1099-MISC for the year showing what he or she was paid (if it amounts to $600 or more), and that’s it. The independent contractor will be responsible for paying self-employment taxes on the wages they earn.


Who is considered an “employee?” for federal tax purposes?

This term can vary significantly and it not what most people think it is. An individual generally is an employee if the enterprise he works for has the right to control and direct him regarding the job he is to do and how he is to do it. Otherwise, he is an independent contractor. Some employers that have misclassified workers as independent contractors are relieved from employment tax liabilities under Section 530 of the 1978 Revenue Act (not the Internal Revenue Code).


How do employers treat workers?

In brief, Section 530 protection applies only if the employer: filed all federal returns consistent with its treatment of a worker as an independent contractor; treated all similarly situated workers as independent contractors; and had a “reasonable basis” for not treating the worker as an employee.


Who is an “independent contractor” for federal tax purposes?

For example, a “reasonable basis” exists if a significant segment of the employer’s industry has traditionally treated similar workers as independent contractors. Section 530 doesn’t apply to certain types of technical services workers. Individuals who are “statutory employees,” (that is, specifically identified by the Internal Revenue Code as being employees) are treated as employees for social security tax purposes even if they aren’t subject to an employer’s direction and control (that is, even if the individuals wouldn’t be treated as employees under the common-law rules).


Other Factors to Determine if Independent Contractors

These individuals are agent drivers and commission drivers, life insurance salespeople, home workers, and full-time traveling or city salespeople who meet a number of tests. Statutory employees may or may not be employees for non-FICA purposes. Corporate officers are statutory employees for all purposes. Individuals who are statutory independent contractors (that is, specifically identified by the Internal Revenue Code as being non-employees) aren’t employees for purposes of wage withholding, FICA, or FUTA and the income tax rules in general. These individuals are qualified real estate agents and certain direct sellers.


Special Circumstances with Independent Contractors

Some categories of individuals are subject to special rules because of their occupations or identities. For example, corporate directors aren’t employees of a corporation in their capacity as directors, and partners of an enterprise organized as a partnership are treated as self-employed persons. Under certain circumstances, you can ask IRS (on Form SS-8) to rule on whether a worker is an independent contractor or employee.


Penalties for Independent Contractors v. Employees – Misclassification

What the IRS is looking for are workers who are treated as independent contractors but who actually are employees. If the IRS is successful in reclassifying workers, there is the potential of a substantial tax bill, consisting of, just for starters, the employer’s back social security taxes and FUTA taxes, plus possible penalties and interest.


What are the caps on independent contractors penalties?

The amounts involved are significant. For 2015, in addition to income tax withholding, the employer is required to withhold 6.2 percent from taxable wages up to a wage base of $118,500 for the Old Age, Survivors and Disability and Insurance (OASDI) portion of the Federal Insurance Contributions Act (FICA). The HI portion (Medicare) of the tax has no wage cap. Proper worker classification is essential to insure the a company is not at risk for any penalties or fines.