Worker classification is important because it determines if an employer must withhold income taxes and pay Social Security, Medicare taxes, and unemployment tax 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.
Mistakenly classifying an employee as an independent contractor can result in significant fines and penalties. Although there is no black and white guidance on this issue, there are 20 factors used by the IRS to determine whether you have enough control over a worker to be an employer. Though these rules are intended only as a guide, the IRS indicates that the importance of each factor depends on the individual circumstances. Ultimately, the combination of factors will point to whether or not an organization wields enough control to point to an employer-employee relationship.
20 Point Test
If you answer “Yes” to all of the first four questions, you likely have an independent contractor relationship. “Yes” to any of questions 5 through 20 means your worker is more likely to be an employee.
- Profit or loss. Can the worker make a profit or suffer a loss as a result of the work, aside from the money earned from the project? (This should involve real economic risk-not, just the risk of not getting paid.)
- Does the worker have an investment in the equipment and facilities used to do the work? (The greater the investment, the more likely independent contractor status.)
- Works for more than one firm. Does the person work for more than one company at a time? (This tends to indicate independent contractor status but isn’t conclusive since employees can also work for more than one employer.)
- Services are offered to the general public. Does the worker offer services to the general public?
- Do you have the right to give the worker instructions about when, where, and how to work? (This shows control over the worker.)
- Do you train the worker to do the job in a particular way? (Independent contractors are already trained.)
- Are the worker’s services so important to your business that they have become a necessary part of the business? (This may show that the worker is subject to your control.)
- Services rendered personally. Must the worker provide the services personally, as opposed to delegating tasks to someone else? (This indicates that you are interested in the methods employed, and not just the results.)
- Hiring assistants. Do you hire, supervise, and pay the worker’s assistants? (Independent contractors hire and pay their own staff.)
- Continuing relationship. Is there an ongoing relationship between the worker and yourself? (A relationship can be considered ongoing if services are performed frequently but irregularly.)
- Work hours. Do you set the worker’s hours? (Independent contractors are masters of their own time.)
- Full-time work. Must the worker spend all of his or her time on your job? (Independent contractors choose when and where they will work.)
- Work done on premises.Must the individual work on your premises, or do you control the route or location where the work must be performed? (Answering no doesn’t by itself mean independent contractor status.)
- Do you have the right to determine the order in which services are performed? (This shows control over the worker)
- Must the worker give you reports accounting for his or her actions? (This may show a lack of
- Pay Schedules. Do you pay the worker by the hour, week, or month? (Independent contractors are generally paid by the job or commission, although by industry practice, some are paid by the hour.)
- Do you pay the worker’s business or travel costs? (This tends to show control.)
- Tools and materials. Do you provide the worker with equipment, tools, or materials? (Independent contractors generally supply the materials for the job and use their own tools and equipment.)
- Right to fire. Can you fire the worker? (An independent contractor can’t be fired without subjecting you to the risk of a breach of contract lawsuit.)
- Worker’s right to quit. Can the worker quit at any time without incurring liability? (An independent contractor has a legal obligation to complete the contract.
Risks of Misclassifying Independent Contractors and Employees
- IRS may require employers to pay both their share and the employee’s share of FICA tax, as well as the employee’s portion of FUTA and income taxes.
- Penalties may be assessed in the amount of 1.5% of the employee’s federal income tax liability, plus a 20% penalty against the amount of FICA tax that should have been withheld.
- Companies caught misclassifying workers may have to pay an additional penalty equal to 10% of the unpaid unemployment and disability insurance that was supposed to be withheld.
- Companies can be charged with a misdemeanor that carries a $1,000 fine, a one-year jail sentence, or both.
- Finally, the employee that was misclassified can also take legal action against the employer and seek up to three years of unpaid wages and penalties.
If you have determined you are working with an independent contractor, then IRS regulations state you will have to issue a 1099-NEC at year end. But like many IRS regulations, it’s not quite so simple. But there are some helpful guidelines to determine whether a 1099-NEC is needed.
- Is the payment more than $600? The first rule of thumb is that the payment must be at least $600. If it’s less than that amount, a 1099-NEC is not required and should not be issued.
- Is the payment for services? A 1099-NEC is used to report monies paid for services — not physical products.
- Is the service performed for business purposes? If the payments were for personal services, you don’t need to file a 1099. For example, Say you contract with a worker to remodel your office breakroom. The total comes to $5,000. You would likely issue a 1099-NEC in this case. But let’s say you contracted that same worker to remodel the kitchen in your home. In this case, you don’t need to file a 1099-NEC because the kitchen remodeling was for personal, not business reasons
When in Doubt
If you’re unsure, it’s always best to file a 1099-NEC. There’s no penalty if you file one, but you didn’t need to. On the other hand, not filing one that is required can lead to hefty penalties.
And one more tip: Always get the W-9 before you issue payments to any vendor who may be required to get a 1099-NEC. Less-reputable vendors might not be around when you need their information at tax time
Source: IRS, Small Business Trends