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Independent
Contractor or Employee?
You
may be one of the many individuals who are surprised to find out
the tax consequences of independent contract work. Whether
you are receiving money as an independent contractor or paying
someone to do work for you as an independent contractor you need
to understand the full tax consequences of your working
arrangement.
As you probably know, if a worker is an employee, the business
(payer) must withhold federal income and payroll taxes, must pay
the employer's share of FICA taxes on the wages plus FUTA tax,
and may have to provide the worker with fringe benefits it makes
available to other employees. There may be state tax obligations
as well.
These
obligations don't apply to a worker who is an independent
contractor. The business sends the independent contractor a Form
1099-MISC for the year showing what he or she was paid (if it
amounts to $600 or more) and that's it.
Who
is an “employee”? There is no uniform definition of the
term. The question of whether a worker is an independent
contractor or employee for federal income and employment tax
purposes is a complex one. It is intensely factual, and the
stakes can be very high.
Under
the Common Law Rules (so-called because they originate from
court cases rather than from the tax code) 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 '78 Revenue Act (not the Internal Revenue
Code). 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.
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 tax 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). Examples of statutory employees 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 tax code as being non-employees) aren't
employees for purposes of wage withholding, FICA or FUTA, and
the income tax rules in general. Examples are qualified real
estate agents and certain direct sellers.
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. Partners of an enterprise organized as a partnership
are treated as self-employed persons.
Under
certain circumstances, you can ask the IRS (on Form SS-8) to
rule on whether a worker is an independent contractor or
employee.
In
determining whether the person providing service is an employee
or an independent contractor, all information that provides
evidence of the degree of control and independence must be
considered.
Common
Law Rules
Facts
that provide evidence of the degree of control and independence
fall into three categories:
-
Behavioral: Does the company control or have the right to
control what the worker does and how the worker does his or
her job?
-
Financial: Are the business aspects of the worker’s job
controlled by the payer? (These include things like how
worker is paid, whether expenses are reimbursed, who
provides tools/supplies, etc.)
-
Type of Relationship: Are there written contracts or employee type
benefits (i.e., pension plan, insurance, vacation pay,
etc.)? Will the relationship continue and is the work
performed a key aspect of the business?
1.
Behavioral
Control
Behavioral
control refers to facts that show whether there is a
right to direct or control how the worker does the work. A
worker is an employee when the business has the right to direct
and control the worker. The business does not have to actually
direct or control the way the work is done – as long as the
employer has the right to direct and control the work.
The
behavioral control factors fall into the categories of:
Types
of Instructions Given
An
employee is generally subject to the business’s instructions
about when, where, and how to work. All of the following are
examples of types of instructions about how to do work.
-
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 work must be
performed by a specified individual
-
What order or
sequence to follow when performing the work
Degree
of Instruction
Degree
of Instruction means that the more detailed the instructions,
the more control the business exercises over the worker. More
detailed instructions indicate that the worker is an employee.
Less detailed instructions reflects less control, indicating
that the worker is more likely an independent contractor.
Note: The amount of instruction needed varies among
different jobs. Even if no instructions are given, sufficient
behavioral control may exist if the employer has the right to
control how the work results are achieved. A business may lack
the knowledge to instruct some highly specialized professionals;
in other cases, the task may require little or no instruction.
The key consideration is whether the business has retained the
right to control the details of a worker's performance or
instead has given up that right.
Evaluation
System
If an evaluation system measures the details of how the work is performed,
then these factors would point to an employee.
If
the evaluation system measures just the end result, then this
can point to either an independent contractor or an employee.
Training
If the business provides the worker with training on how to do the job,
this indicates that the business wants the job done in a
particular way. This is strong evidence that the worker is
an employee. Periodic or on-going training about procedures and
methods is even stronger evidence of an employer-employee
relationship. However, independent contractors ordinarily use
their own methods.
2.
Financial Control
Financial
control refers to facts that show whether or not the business
has the right to control the economic aspects of the worker’s
job.
The
financial control factors fall into the categories of:
Significant
Investment
An
independent contractor often has a significant investment in the
equipment he or she uses in working for someone else.
However, in many occupations, such as construction, workers
spend thousands of dollars on the tools and equipment they use
and are still considered to be employees. There are no precise
dollar limits that must be met in order to have a significant
investment. Furthermore, a significant investment is not
necessary for independent contractor status as some types of
work simply do not require large expenditures.
Unreimbursed
Expenses
Independent
contractors are more likely to have unreimbursed expenses than
are employees. Fixed ongoing costs that are incurred regardless
of whether work is currently being performed are especially
important. However, employees may also incur unreimbursed
expenses in connection with the services that they perform for
their business.
Opportunity
for Profit or Loss
The
opportunity to make a profit or loss is another important
factor. If a worker has a significant investment in the
tools and equipment used and if the worker has unreimbursed
expenses, the worker has a greater opportunity to lose money
(i.e., their expenses will exceed their income from the work).
Having the possibility of incurring a loss indicates that the
worker is an independent contractor.
Services
Available to the Market
An
independent contractor is generally free to seek out business
opportunities. Independent contractors often advertise, maintain
a visible business location, and are available to work in the
relevant market.
Method
of Payment
An
employee is generally guaranteed a regular wage amount for an
hourly, weekly, or other period of time. This usually indicates
that a worker is an employee, even when the wage or salary is
supplemented by a commission. An independent contractor is
usually paid by a flat fee for the job. However, it is common in
some professions, such as law, to pay independent contractors
hourly.
3.
Type of Relationship
Type
of relationship refers to facts that show how the worker and
business perceive their relationship to each other.
The
factors for the type of relationship between two parties
generally fall into the categories of:
Written
Contracts
Although
a contract may state that the worker is an employee or an
independent contractor, this is not sufficient to determine the
worker’s status. The IRS is not required to follow a
contract stating that the worker is an independent contractor,
responsible for paying his or her own self employment tax.
How the parties work together determines whether the worker is
an employee or an independent contractor.
Employee
Benefits
Employee
benefits include things like insurance, pension plans, paid
vacation, sick days, and disability insurance. Businesses
generally do not grant these benefits to independent
contractors. However, the lack of these types of benefits
does not necessarily mean the worker is an independent
contractor.
Permanency
of the Relationship
If
you hire a worker with the expectation that the relationship
will continue indefinitely, rather than for a specific project
or period, this is generally considered evidence that the intent
was to create an employer/employee relationship.
Services
Provided as Key Activity of the Business
If
a worker provides services that are a key aspect of the
business, it is more likely that the business 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. This would indicate
an employer/employee relationship.
Businesses
must weigh all these factors when determining whether a worker
is an employee or independent contractor. Some factors may
indicate that the worker is an employee, while other factors
indicate that the worker is an independent contractor. There is
no “magic” or set number of factors that “makes” the
worker an employee or an independent contractor, and no one
factor stands alone in making this determination. Also, factors
which are relevant in one situation may not be relevant in
another.
The
keys are to look at the entire relationship, consider the degree
or extent of the right to direct and control, and finally, to
document each of the factors used in coming up with the
determination.
If
you'd like to discuss these complex rules with me and see how
they apply to your business in order to make sure that none of
your workers are misclassified, please call my office to arrange
for an appointment.
What
Do You Do if You Forget to Send Out 1099's by the February 1
Deadline?
If
you are a small business owner or self-employed person who hires
independent contractors you may be required by the IRS to send
out a Form 1099-MISC to those people. Read the following to help
you determine your obligation to issue 1099's.
The basic rule works like this: Form 1099-MISC is used to report
total annual payments made to independent contractors who made
at least $600 during the previous calendar year. This 1099 must
be given or mailed to the contractor by January 31 of the
following year.
Note: Since January 31, 2010 was a Sunday, the deadline
was extended to the next business day (Monday, Feb. 1, 2010).
The key here is whether or not the person who worked for you is
self-employed. Obviously, this excludes employees. If you have
employees, you give them a Form W-2 by January 31 (or Feb. 1) to
report their compensation (wages, salaries, bonuses, and
withholdings). This also means you don't have to send out a
1099-MISC to corporations who provided services to your
business.
The
purpose of the 1099-MISC is similar to that of the W-2, but the
goal here is to report income made by non-employees, not
employees. This is why the annual total income of self-employed
contractors is reported in Box 7 of the 1099, "Nonemployee
Compensation."
The 1099s provide a way to track payments and the IRS is
expecting you to help them keep track of the income of the
self-employed.
There
are many self-employed workers who receive no 1099's, and report
no income, even though the law says they are supposed to report
the income whether or not they receive a 1099.
Keep in mind that if you take a deduction for payments to
independent contractors but don't issue the corresponding
1099's, and you get audited, you will have to pay the tax,
punitive penalties and interest or possibly worse. Don't take
chances... go ahead and issue the 1099's.
What if the February 1 deadline has already passed? Go ahead and
issue the 1099's anyway. Give the contractor a call right away
and tell him you are sending him a 1099 as soon as possible.
For details on how to comply with the 1099 reporting rules, download the
Form 1099-MISC instructions from the IRS website or consult with
your tax professional. You'll want to send Form 1099-MISC Copy B
to the self-employed person right away and Form 1099-MISC Copy
A, along with Form 1096, to the IRS by March 1, 2010.
Ralph
Sayers, CPA
(877)
316-4331
ralphs@tampabay.rr.com |
