The Internal Revenue Service reminds small businesses of the importance of understanding and correctly applying the rules for classifying a worker as an employee or an independent contractor. For federal employment tax purposes, a business must examine the relationship between it and the worker.
Worker classification is important because it determines if an employer must withhold income taxes and pay Social Security taxes, Medicare taxes, and unemployment taxes on wages paid to an employee. Businesses normally do not have to withhold or pay any taxes on payments to independent contractors. The earnings of a person working as an independent contractor are subject to self-employment tax.
The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done. Small businesses should consider all evidence of the degree of control and independence in the employer/worker relationship. Whether a worker is an independent contractor or employee depends on the facts in each situation.
Help to Decide:
To better determine how to properly classify a worker, consider the following three categories-Behavioral Control, Financial Control and relationship of the parities.
- Behavioral Control: A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. Behavioral control categories are:
Type of instructions given
Degree of instructions
- Financial Control: Does the business have a right to direct or control the financial and business aspects of the worker’s job? Consider:
Significant investment in equipment
Opportunity for profit or loss
Services available to the market
Method of payment
- Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. This includes:
The permanency of the relationship
Consequences of Misclassifying an Employee:
Classifying an employee as an independent contractor with no reasonable basis for doing so makes employers liable for employment taxes. Certain employers that can provide a reasonable basis for not treating a worker as an employee may have the opportunity to avoid paying employment taxes.