As a business owner there are certain important decisions you must make every day, one of them includes the distinction every time you hire paid help. Is this new worker classified as an employee or an independent contractor?
This answer is quite important because misclassifying an employee as an independent contractor can lead you in court and in trouble for debt with payroll taxes.
In the eyes of the IRS, there are four classifications for workers:
- Independent Contractor
- Statutory Employee
- Statutory Non-Employee
The two most common for the business owners are Employee and Independent Contractor.
If the worker is classified as an Independent Contractor, there is a bit less leg work for the employer and more responsibility on the worker. An Independent contractor is responsible to pay for his or her own taxes. There are fewer employment laws for both the employer and the independent contractor to keep up with. The status of an independent contractor is defined by the law, not by any agreement the employer and the worker make. As the employer you must pay the contractor and also arrange Forms W-9 and 1099-MISC, to meet IRS requirements and regulations.
If your worker is classified as an employee, you’ll need to withhold, deposit, report, and pay employment taxes as well as Social Security and Medicare Taxes. If these amounts are not correctly withheld or paid, the IRS may flag your business and come after any money owed.
IRS Guidance: Employee vs. Independent Contractor
The IRS has created some general guidelines and criteria to help business owners make this important distinction.
The general rule is that an individual is an independent contractor when the payer has the right to control or direct only the result of their work and not how and what will be done.
When you need to classify your new worker, there are three factors to consider:
If the worker is paid on salary or per hour, they are likely designated as an employee. On the other hand, if the employee is paid per diem or a flat fee per job or project, this is more likely an independent contractor.
If the employer trains the worker and exercises the right to control the worker’s time, working habits, hours, and dictates how work is completed then the individual is most likely an employee. On the other hand, if the worker is there to accomplish and specific task and decides their own hours, how the work gets done, and even hire their own assistance, they are most likely an independent contractor.
Type of Relationship
The relationship and line of work the employer and the worker have also effects the classification of employee vs. independent contractor. For example, if the work being done is in the general line of work the company does then this could be an employee. On the other hand, if the worker is providing a service that is outside the general line of work, this could be an independent contractor.
For example, if a local diner hires a worker to serve food and take customers orders this would most likely be an employee. Alternatively, if you are hiring an interior designer to customize the diner’s ambiance and decoration then you are most likely hiring an independent contractor.
Why You Should Not Misclassify Employees
The big reason is the consequence related to the IRS. If the IRS finds out a business is misclassifying their employees as independent contractors whether it be on accident or for financial gain, the business would need to pay back taxes and all penalties associated to having an employee. These include, income taxes, social security, Medicare and unemployment taxes.
The Federal Labor Standards Act is also something employers should be in line with. If a worker decides they are being misclassified, they can file a law suit against the employer. One of the most common reasons for litigation in employee misclassifications is failure to pay over-time and failure to pay minimum wage. This generally results when an independent contractor eventually becomes dissatisfied with the long hours or mental duties than come with accomplishing their task.
Get the Forms Right before they Bite: 1099, W-2, or W-9
As the business owner you will need to know which tax forms to file when hiring a new employee or independent contractor.
For each employee you will need a W-2 form, as well as withholding and paying taxes and benefits.
For each independent contractor you work with and pay more than $600 during the tax year, you’ll need a Form W-9 or Form 1000-MISC.
Understanding the importance and distinguishing weather your worker is an employee or independent contractor off the bat, can save you a lot of trouble in the long run. If you get it right, you will feel empowered and hiring the right worker for your business will be a breeze time and time again. This will also give you a peace of mind with the law and IRS requirements, knowing you and your business are compliant.
For more of these easy to understand guides, tips, or even fun facts, check out the rest of our Tax Blogs.