Should a worker be treated as an employee or an independent contractor? There are legal differences between the two — and major tax distinctions as well.
For an employee, a business must generally withhold income and FICA (Social Security and Medicare) taxes from the employee’s pay and remit those taxes to the government. In contrast, a business is not required to withhold income or FICA taxes for an independent contractor. The contractor is fully liable for his or her own self-employment taxes, and FICA and federal unemployment taxes do not apply. Generally, if a business has made payments of $600 or more to an independent contractor, it must file an information return (Form 1099-MISC) with the IRS and send a corresponding statement to the independent contractor.
Determining who’s who
Is a worker an independent contractor or an employee? The IRS examines factors in three categories:
- Behavioral control — the extent to which the business controls how the work is done, whether through instructions, training or otherwise
- Financial control — the extent to which the worker has the ability to control the economic aspects of the job. Factors considered include the worker’s investment and whether he or she may realize a profit or loss
- Type of relationship — whether the worker’s services are essential to the business, the expected length of the relationship, and whether the business provides the worker with employee-type benefits, such as insurance, vacation pay, sick pay, etc.
When the proper classification is unclear, the business or the worker may obtain an official IRS determination by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
Consequences of misclassification
When an employer misclassifies an employee as an independent contractor, the IRS may impose penalties for failure to deduct and withhold income and/or FICA taxes. Penalties may be doubled if the employer also failed to file a Form 1099-MISC, though the lower penalty will apply if the failure was due to reasonable cause and not willful neglect.
Employers with misclassified workers may be able to correct their mistakes through the IRS’s Voluntary Classification Settlement Program (VCSP). For employers that meet the program’s eligibility requirements, the VCSP provides the following benefits:
- Workers improperly classified as independent contractors are treated as employees going forward
- The employer pays 10% of the most recent tax year’s employment tax liability for the identified workers, determined under reduced rates (but no interest or penalties)
- The government agrees not to raise the issue of the workers’ classification for prior years in an employment tax audit
Your tax advisor can help you sort through the IRS rules and fulfill your tax reporting obligations. Have questions? Reach out to the tax experts at Magone & Company today at (973) 301-2300.