The distinction between employees and independent contractors is important. The status of someone who works in your business makes a difference in how you pay them and in how they pay taxes.
Employees and Independent Contractors – Defined
Employees (sometimes called common law employees) are individuals who works for an employer that controls the work of the employee – what will be done and how it will be done.
Independent contractors are professionals or workers who are in a trade or business offering their services to the general public. People like doctors, dentists, building contractors, and freelancers are considered independent contractors. Independent contractors are considered to be self-employed and their earnings are subject to self-employment tax (Social Security and Medicare).
Why Correct Worker Status is Important
Determining whether a worker is an independent contractor (IC) or an employee is important because it determines whether payroll taxes (income taxes and FICA taxes) are withheld from the person's payment. You must withhold payroll taxes from employee pay, but you don't withhold taxes from payments to independent contractors. The IRS determines worker status for these purposes.
Worker status (IC or employee) is also important for pay and benefits status. Only employees are protected by the Dept. of Labor's wage and hour law, the Fair Labor Standards Act. This act sets rules for minimum wages, overtime, child labor, OSHA, and other protections.
Because IRS and DOL rules are different, a worker may be classified as an employee under one rule and as an independent contractor under another. Get help from an employment attorney to figure this out for your business.
How the IRS Determines Worker Status
The IRS uses three basic rules to determine the type of business relationship between the worker and employer, based on the degree of control and independence of the worker
Behavioral control looks at the degree of control the employer has over workers. Does the employee give many detailed directions, including where and when to do the work? Does the employer do training (implying that the worker may not be skilled already)? Does the employer have evaluation systems built in to monitor worker performance? Does the worker bring their own tools and supplies, or does the employer provide them?
This factor includes how the worker is paid, whether the worker may work for others at the same time, and whether the worker can incur a profit or loss. A worker who is paid a salary is restricted from working for others, and who does not participate in company profits or losses, is probably an employee.
Type of Relationship
The presence of a specific contract may indicate an independent contractor, but this factor alone is not controlling. If the worker is entitled to benefits, this would indicate an employment relationship. Another factor would be the type of work the person does; if it is directly related to the company's core work, they are probably an employee. For example, a maintenance worker would not be doing 'company' work if they were working for a bank.
The IRS looks at employee vs. independent contractor designations on a case-by-case basis. They assume the person is an employee.
Getting a Worker Status Determination from the IRS
It is sometimes difficult to determine the status of a worker, but if you are unsure, assume the worker is an employee in the eyes of the IRS. If you want to find out whether to classify a worker as an independent contractor or employee, you can file a Form SS-8 to request a determination from the IRS. The IRS doesn't issue determinations on hypothetical situations, but only for in order to resolve federal tax matters.
New Dept. of Labor Rules for Determining Worker Status
The U.S. Department of Labor has announced new rules to make it easier to determine whether a worker is an independent contractor vs. an employee.
The new DOL regulation has been put on hold by the Biden administration, along with other proposed regulations, until all have been reviewed.
An economic reality test to determine whether the worker is in an independent business or is an employee, dependent on an employer for work
Two "core factors" to help clarify whether the worker is economically independent: the nature and degree of control over the work and the worker's opportunity for profit or loss based on initiative and/or investment
Several additional factors for further clarification:
- The amount of skill required for the work
- The degree of permanence of the working relationship
- Whether the work is an essential part of the business product
The DOL also noted that the reality of the situation is more important than having a contract.
Another Possible Status for Workers
Just to confuse things, there is another possible status for workers, called a statutory employee (or non-employee). A statutory employee is a cross between an employee and an independent contractor; they are treated as a worker outside the company, but they are treated as an employee for employment tax purposes and like an independent contractor for income tax purposes.
Only four specific categories of workers can be designated as statutory employees:
- Some drivers who distribute (non-milk) beverages, meat, produce, or bakery products, if they are agents of your company and paid on commission.
- Full-time life insurance agents selling insurance primarily for one company
- Piece workers who work at home on materials or goods you supply. You specify the work to be done and the goods or materials are returned to you.
- A full-time traveling or city salesperson, if the work performed for you is this person's principal business. The person turns in orders to you and the goods sold must be merchandise for retail or supplies used in the buyer's business.
How Employees and Independent Contractors Pay Taxes
Employees are paid as salaried or hourly, on commission, or a combination, and may be subject to overtime. Employees are taxed on their income, and they receive a W-2 form showing their annual income), and you must also withhold federal and state income taxes and FICA taxes (Social Security and Medicare) from them. Your business must also make FICA tax payments.
If someone is working for your business as an independent contractor, you don't withhold federal or state income taxes and FICA taxes from the amounts you pay them unless they are subject to backup withholding.
Your business also isn't required to make payments for Social Security and Medicare for independent contractors. The independent contractor must pay these Social Security/Medicare taxes as self-employment taxes on the payments they receive.
You must send each independent contractor an annual 1099-NEC form (beginning in 2020) if you paid that person $600 or more during the year.