IRS Worker Classification: Independent Contractor vs Employee

If you’re a business owner who utilizes independent contractors, it is crucial for you to be aware of the differences between an independent contractor and an employee in terms of how the IRS defines each.

While there are tax benefits to using independent contractors rather than hiring employees, you must be very careful in making sure that you have a true independent contractor relationship; otherwise, you run the risk of incurring IRS penalties.

In order to recover billions of dollars in lost tax revenue, the IRS is cracking down on businesses that wrongly classify their employees as independent contractors. If you run a business that hires independent contractors, here is what you will need to know in order to maintain full IRS compliance:

The Difference between Independent Contractors and Employees

If you are unsure as to whether your hired help should be classified as an independent contractor or an employee, the IRS offers criteria to help you figure it out. The primary factor that you need to look at is the level of control that you have over your hired help. If you have control of not only when the work needs to be completed, but also how it is completed, when it is worked on, how much time is put into completing the work, etc., then that worker will most likely be categorized as an employee. If your control is limited to project deadlines and final product outcome, and you have no control over when or how the project is actually completed, then you have most likely hired an independent contractor.

An additional criterion to consider is the way in which you financially support those that you hire. That is, do you reimburse for expenses, pay for training or provide supplies or tools? If so, then those workers will be classified as employees. If you provide any type of employment benefits – such as pension plans, vacation pay, sick leave, personal days or health insurance – then those workers will also be considered employees.

Tax Implications of Misclassifying Workers

According to the IRS, if you misclassify an employee as an independent contractor, you may be susceptible to stiff fines and penalty fees. You will most likely be held accountable for all past employment payroll taxes – including Medicare, Social Security and unemployment taxes – as well as additional penalty fees incurred for not paying those taxes in the first place. You may also be assessed penalty fees for not filing certain required tax forms.

How to Protect Yourself

If you are an employer who hires independent contractors, here are some guidelines to help you protect your business from incurring IRS fines and penalties:

1. When you hire an independent contractor, make sure that you have a signed agreement outlining exactly what your relationship is.
2. Do not provide any benefits – such as health insurance, education and training, or sick days – to independent contractors.
3. Only give tasks, deadlines and amounts paid per task to your independent contractors. You cannot ask an independent contractor to complete a task in a certain way or tell him what hours to work.
4. Always have your independent contractors invoice you for completed projects. Keep all invoices on file.
5. Never supply an independent contractor with tools or any other items needed to complete a project, as he must use his own tools and equipment.
6. Make sure that you are not the only company that the independent contractor does business with.

Determining Whether You’ve Hired Employees or Independent Contractors

When trying to determine whether a worker that you’ve hired should be considered an employee or independent contractor, you must look carefully at all the differences listed above. In many cases, there is a clear cut answer, but if you are still unsure then the IRS can help you decide. If you’re having trouble classifying your workers, you can file IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. Either party – the business or the worker – can file the form with the IRS. The IRS will then review the information provided and make a determination as to whether the worker is an employee or an independent contractor.

Additionally, it is always a good idea to seek the help of a tax expert, who can not only give you a more clear understanding of how you should be classifying your workers, but also make sure that you’re paying all of the necessary taxes and filing all of the required forms in order to maintain IRS compliance.