Tell the Difference Between an Employee and an Independent Contractor
Employers must beware of the federal and state crackdowns on the use of independent contractors to avoid payroll tax problems and employment tax audits. But how do you distinguish between independent contractors and employees? More importantly, how does the IRS determine who owes unpaid employment taxes and who doesn’t? Consider these tips to make correct determinations of worker classifications and avoid the wrath of IRS audits for unpaid employment taxes and payroll tax problems.
Steps
- Ask yourself, “Who’s in charge?” In business audits, the IRS uses three general criteria to determine the relationship between companies and workers: 1) Behavioral Control - does the business direct or control how the work is done and what hours the employee works? 2) Financial Control - does the business direct or control the financial and business aspects of the worker? 3) Type of Relationship - how do the worker and business owner perceive their relationship? If the company is determining only what work is done, their workers are probably independent contractors. On the other hand, if they control not only what is done, but how it is done (when, where, etc.), then the workers are probably employees.
- Determine where the buck stops. What risk of loss does the worker have? Do they pay for and use their own tools (computer, printer, high-speed, etc.), or do you provide them with what they need? When it comes to employment tax audits, the worker carrying the liability is an independent contractor.
- Check the name on the check. To avoid unpaid employment taxes, discover if your accounting department is writing checks to “Jane Doe” or “Jane Doe, Inc.” If the worker is doing business under a DBA fictitious business name, LLC or other organizational umbrella, an employment tax audit would most likely declare that person a contractor.
- Ask them to sign an exclusivity agreement. Most independent contractors juggle many clients at a time. If your worker refuses to sign an exclusivity agreement, they are likely working for other companies and consider themselves free agents. An employment tax audit or business audit would consider them an independent contractor.
- Ask whether they want a W-2 or 1099. If you’re in need for tax relief the best defense against unpaid employment taxes is in the paperwork. An experienced independent contractor will ask for a 1099 form and pay their own taxes to avoid payroll tax problems. If you’re hiring an independent contractor for the first time, it is incumbent upon you to ensure that they know what their responsibilities are and avoid unpaid employment taxes.
- When in doubt, ask the IRS to make the determination. Both employers and workers can ask the IRS to determine whether a worker is an independent contractor or an employee. All you need to do is file a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS. They will apply a 20-point common law test, internal revenue code section 5-30, that determines whether that person is an employee or an independent contractor.
- Visit irs.gov and select the Small Business link. Additional resources include IRS Publication 15-A, Employer's Supplemental Tax Guide, Publication 1779, Independent Contractor or Employee, and Publication 1976, Do You Qualify for Relief under Section 530? These publications and Form SS-8 are available on the IRS website or by calling the IRS at 800-829-3676
