Employee or Independent Contractor?
How to avoid paying excessive Social Security (Federal Insurance Contributions Act or FICA) Taxes (and related Medicare and self-employment (Self-Employment Contributions Act or SECA) taxes ).
Generally there is no payroll tax due on trading gains. Most other types of income from your trade or business are subject to these taxes.
The tried and true s-corporation method used by aggressive taxpayers including members of the U.S. Congress themselves, is under increased scrutiny with an increase in s-corp audits, looking for wages paid to the shareholders that are deemed to be “too low.”
Caution: We’ve had taxpayers come to us after being sold a bill of goods by websites proclaiming that the S-corp is the latest entity of choice for traders. Only to find out that after a few years of less than stellar trading gains, the IRS still needed to see reasonable wages paid, along with delinquent payroll taxes, penalties and interest thereon.
Shareholders of s-corps should pay themselves an appropriate salary and be able to support the amount when the IRS comes asking if it is at an appropriate level.
Paying rent to the shareholders for property used by the corporation is also free from payroll taxes.
The independent contractor method, used to avoid the employer’s 50% match share of the withholding taxes is also under increased scrutiny, but effective with 2007 the penalties for getting “caught” are not as bad as one might think.
When the IRS reclassifies your contractors as employees you can pay reduced penalties if the misclassification was not intentional. Federal income tax withholding is only 1.5% of wages, far below the normal level. The rate for the employees’ share of FICA is capped at 1.53%. If 1099-MISC were not timely filed for the contractors, then the penalty rates are doubled.
Patient Protection and Affordable Care Act (PPACA) – commonly called Obama Health Care Legislation or Obamacare – the 0.9% earned income surcharge-tax and the 3.8% investment income surcharge-tax.
Note the logic here: Medicare tax is 1.45% withholding from employees, which is then matched by another 1.45% by the employer. To this add the 0.9% surcharge-tax. The total of these three is 3.8%. The attempt here is to catch as many taxpayers as possible with a 3.8% tax on income over $250,000.
Employee Advances vs. Employee Loans
Employee Advances are taxed as wages when they are advanced to an employee.
Employee Loans can be considered monetary debts and then would not be taxed as wages.
The lending of money is a debtor-creditor relationship and generally is not taxable.
The question whether a debtor-creditor relationship is created at the time an employee advance is received is a question of fact to be determined upon a consideration of all the evidence. An essential element is the intent of the recipient to make monetary repayment of the amount of the advance and the intent of the person advancing the funds to enforce such repayment. See Irving D. Fisher, 54 T.C. 905, (alternate site) and cases cited therein.
At the time the advances are made is it the understanding that the employee would satisfy them by foregoing salary payments for future periods? If so, then this clearly indicates that satisfaction is to be made by the rendition of services in the future. Thus, there is no debtor-creditor relationship created at the time the advances are made and therefore such advances do not constitute loans. Such advances are consistently treated as compensation for services by the IRS.
See Starke vs. Commissioner T.C. Summary Opinion 2015-40
In the case of a loan, which is not included in income at the time the funds are disbursed, the parties agree that the amount will be repaid and the debtor-creditor relationship is established at the outset. (see Commissioner v. Tufts, 461 U.S. 300, 307 1983). However, an advance that is considered compensation for services, albeit services to be rendered in the future, constitutes taxable income in the year it is received. (see Beaver v. Commissioner, 55 T.C. at 91)
Example: “XYZ Company” gives “Bob,” an employee, a $100 advance on September 29, 2017. Bob’s next payday is October 6, 2017. XYZ Company is required to withhold all payroll taxes from the $100 advance on September 29, 2017, and report the advance as wages on the September payroll tax forms.
IRS / State crackdown
Employee vs. independent contractor – when W-2 was not issued, or was issued incorrectly:
IRS Publication 1779 “Independent Contractor or Employee”
TAX-FAVORED BENEFITS AVAILABLE TO EMPLOYEES AND INDEPENDENT CONTRACTORS
To Employee in Employer’s Plan
To Independent Contractor in Client’s Plan
To Independent Contractor in Own Plan
|Employee achievement awards||
|Group-term life insurance||
|Accident and health insurance||
Limited exclusion only
Limited deduction only
|Meals and lodging||
|Group legal services||
|Qualified employee discounts||
|Working condition fringes||
|De minimis fringes||
|Qualified transportation fringes||
|On-premises athletic facilities||
|Qualified pensions and annuities||
|Qualified, incentive stock options||
|Employee stock purchase plans||
IRS 20 point test:
For the following questions, a “yes” answer means the worker may be an employee.
- Does the principal provide instructions to the worker about when, where, and how he or she is to perform the work?
- Does the principal provide training to the worker?
- Are the services provided by the worker integrated into the principal’s business operations?
- Must the services be rendered personally by the worker?
- Does the principal hire, supervise and pay assistants to the worker?
- Is there a continuing relationship between the principal and the worker?
- Does the principal set the work hours and schedule?
- Does the worker devote substantially full time to the business of the principal?
- Is the work performed on the principal’s premises?
- Is the worker required to perform the services in an order or sequence set by the principal?
- Is the worker required to submit oral or written reports to the principal?
- Is the worker paid by the hour, week, or month?
- Does the principal have the right to discharge the worker at will?
- Can the worker terminate his or her relationship with the principal any time he or she wishes without incurring liability to the principal?
- Does the principal pay the business or traveling expenses of the worker?
For the following questions, a “yes” answer means the worker may be an independent contractor.
- Does the worker furnish significant tools, materials and equipment?
- Does the worker have a significant investment in facilities?
- Can the worker realize a profit or loss as a result of his or her services?
- Does the worker provide services for more than one firm at a time?
- Does the worker make his or her services available to the general public?
BY MITCHELL L. STUMP AND HANS SPROHGE
MANY INDEPENDENT CONTRACTOR RELATIONSHIPS BEGIN at the request of the service provider, but this is no guarantee the IRS will not challenge the classification. The IRS has final authority for deciding whether a worker is an independent contractor or an employee.
THERE ARE A NUMBER OF BENEFITS TO THE CONTRACTING party of classifying a worker as an independent contractor, including no medical insurance costs, no need to pay retirement benefits and recordkeeping and other administrative cost savings. However, if the IRS later reclassifies a contractor as an employee, the employer faces liability for back payroll taxes, possible criminal sanctions and invalidation of benefit plans.
THE BEST PROTECTION CPAs CAN RECOMMEND TO employers or clients against having a worker successfully seek employee status is to rigorously apply the 20 common-law IRS guidelines for determining whether a service provider is an employee or an independent contractor.
EXERCISING EXCESSIVE CONTROL OVER A SERVICE provider’s activities is one factor the IRS will look at that could put a contracting party at risk of reclassification. Even where companies are following the letter of the law, CPAs should encourage them to be careful and keep a sharp eye on court decisions concerning independent contractor status.
COMPANIES SHOULD NOT DEPEND ON THE INDUSTRY practice safe harbor provisions to avoid independent contractor reclassification. Recent legal decisions point out that even traditional independent contractors such as golf caddies can potentially be reclassified as employees.
MITCHELL L. STUMP, CPA, is a sole practitioner of Mitchell L. Stump, CPA, PA, in Palm Beach Gardens, Florida. He is the author of the Club Tax Book, which covers the accumulation of tax issues specific to private clubs. His e-mail address is email@example.com. HANS SPROHGE, CPA/ABV, PhD, is professor of accountancy at Wright State University in Dayton, Ohio. His e-mail address is firstname.lastname@example.org.
The IRS is responsible for determining whether an individual who provides services to a business is an independent contractor or an employee. Although many independent contractor relationships begin at the request of the service provider, this is no guarantee the IRS will not challenge the classification. In some instances the service provider may later claim employee status, triggering an IRS audit. This article suggests some preventive measures CPAs can recommend employers or clients take to avoid a successful IRS challenge when an independent contractor seeks to be reclassified as an employee.
The GAO estimates that 38% of the employers the IRS examines
have misclassified workers as independent contractors.
Source: Center for a Changing Workforce (www.cfcw.org) and the GAO (www.gao.gov).
Some service providers prefer independent contractor status because of the tax benefits not available to employees, including being able to contribute significant dollars to their own qualified retirement plan and deducting legitimate business expenses. Whatever the provider’s reason for wanting to be classified as an independent contractor, the business remains the entity the IRS and the courts will go after for any misclassification.
Some of the obvious tax and financial benefits to the contracting business of avoiding classifying a service provider as an employee include
- No need to provide medical insurance.
- No payments of retirement benefits.
- No employee payroll taxes.
- Obtaining services at a fixed rate, no matter what the time required to complete the assignment.
- Employee recordkeeping, clerical and other administrative cost savings.
In light of these benefits, it is very easy for a contracting party to give in to the wishes of a potential service provider who wants to be classified as an independent contractor.
However, if the worker is successful in having the IRS reclassify him or her as an employee at some later date, the contracting party faces certain risks:
- Liability for back payroll taxes, plus penalties and interest.
- Court time and costs for any related litigation.
- Out-of-court settlements to make the issue go away.
- Unwelcome attention and embarrassment.
- Criminal sanctions, including imprisonment and fines.
- Personal liability for corporate officers of up to 100% of the amount the employer should have withheld from the employee’s compensation in payroll taxes.
- Invalidation of benefit plans.
A service provider the IRS deems to be an employee can make a variety of claims against the employer. These include:
- Overtime pay under the Fair Labor Standards Act if the hours he or she provided to the contracting party in the past exceeded the standard workweek.
- Retirement benefits.
- Medical coverage for injuries sustained on the contracting party’s property.
- A shift in liability from the service provider to the contracting party for injuries to other people or damage to property.
- A shift in responsibility for harassment charges from the service provider to the contracting party.
- Unemployment claims.
Service providers also could sue for the right to have stock options, participate in profit-sharing plans and receive disability payments, workers’ compensation and more. Businesses generally will not face this problem if they have a quality, ongoing working relationship with their independent contractors. Assuming both parties are following independent contractor classification guidelines, difficulties usually occur only when the relationship sours and the service provider feels unduly harmed.
When it is the service provider who seeks reclassification, the IRS may flag the contracting party for an audit of how it classifies all of its independent contractors. If the audit results in the reclassification of more than one independent contractor as an employee, the financial consequences could be ruinous.
A CASE IN POINT
A California State Court of Appeals decision is a perfect example of how good things can go bad (Jerry Ware v. Workers’ Compensation Appeals Board, Bel-Air Country Club, no. B129578 WCAB nos. VNO 363324 and VNO 366471; see also Claremont Country Club v. Industrial Acc. Com. (1917) 174 Cal. 395). A workers’ compensation appeals board determined Jerry Ware, a golf caddie, was an employee of a country club, not an independent contractor. What went wrong for the club? Ware claimed he sustained various orthopedic injuries while the club “employed” him as a caddie.
The caddie testified he had had a continuous employment relationship with the club and offered a number of factors to prove his point, including having to wear special clothing—including a cap issued by the club—and the need for him to abide by rules of conduct the club established. The club also paid him in cash based on chits signed by the members. Based on these circumstances, in particular the control the club exerted over Ware’s dress, behavior, the services rendered and the payment process, and the fact his services benefited the club, the court concluded an employment relationship had been established and the caddie should be classified as an employee. Without delving into the merits of the case, which may have national ramifications, the point is that given his situation, the caddie found it more beneficial to be considered an employee.
The industry practice safe harbor provision under section 530 of the Revenue Act of 1978 provides businesses with no assurance the IRS will not reclassify a service provider as an independent contractor. In the country club industry, for example, it is common practice to classify caddies as independent contractors. However, as the case points out, a caddie was nevertheless reclassified as an employee. CPAs should advise companies not to overly rely on industry practice when classifying workers. They should consider each case individually and make a prudent decision.
PRACTICAL TIPS TO REMEMBER
Employers can avoid the high costs of having a service provider’s designation changed from independent contractor to employee by vigorously applying the 20 common-law factors. When reviewing these factors, businesses should not put too much emphasis on those in its favor and ignore those that are not.
When classifying workers, CPAs should encourage companies to follow the letter of the law. They should look carefully at recent court decisions as the courts seem anxious to bring service providers under the employee umbrella.
Businesses and workers can use form SS-8 (www.irs.gov/pub/irs-pdf/fss8.pdf) to get IRS help in determining the worker’s status. The questions on the form also highlight factors the IRS considers important in making this determination.
Companies shouldn’t overly rely on industry practices when classifying workers but should, instead, consider each case individually.
SAFEGUARDING AGAINST RECLASSIFICATION
The best protection CPAs can recommend to employers or clients against the potentially ruinous costs of changes in independent contractor status is to rigorously apply the 20 common-law factors the IRS developed to help businesses determine whether an individual is an employee or independent contractor (see exhibit on page 90). The factors are intended as guidelines, not as strict rules. The IRS itself says, “the degree of importance of each factor varies depending on the occupation and the factual context in which the services are performed.” The IRS developed the factors based on relevant cases and rulings. They focus on the substance of the arrangement—whether the person for whom the services are performed exercises sufficient control to classify the worker as an employee.
For additional guidance CPAs should help the contracting party review these resources:
Revenue ruling 87-41 and description of employment status under section 530(d) of the Revenue Act of 1978.
Sections 31.3121(d)-1, 31.3306(i)-1 and 31,3401(d)-1 of employment tax regulations, relating to the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA) and the Collection of Income Tax at Source on Wages (chapters 21, 23 and 24 of the Internal Revenue Code).
IRS Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding (www.irs.gov/pub/irs-pdf/fss8.pdf).
Businesses and workers file form SS-8 to ask the IRS to determine a worker’s status for purposes of federal employment and income tax withholding. It includes questions that describe the relationship between the two parties, including the amount and nature of behavioral and financial control. While the form itself does not provide guidance, the questions the IRS poses offer some insight into factors it considers important. The IRS will not issue a determination letter for proposed transactions or hypothetical situations although it may issue information letters.
When considering the 20 common-law factors, the contracting party should resist the temptation to focus on those in its favor and downplay or ignore factors that are not. If a company designates someone as an independent contractor when a majority, but not all, of the 20 common-law factors shows he or she is an employee, it is only asking for trouble.
Exercising excessive control over the activities of a service provider is one of the factors that will put a contracting party at risk of reclassification. In almost every case in which the IRS or the courts overturn an independent contractor relationship, it is obvious there are a number of factors falling into the employee status column. CPAs should encourage companies to proceed with caution and keep a sharp eye on the courts. The judicial trend seems to be to bring the service provider under the contracting party’s umbrella as an employee.
Common-Law Factors Indicating Employee Status
- Instructions. A worker who must comply with other persons’ instructions about when, where and how he or she is to work is ordinarily an employee. This factor is present when the person for whom the services are performed has the right to require compliance.
- Training. Requiring an experienced employee to work with the worker, corresponding with the worker, requiring the worker to attend meetings or using other training methods indicates the person for whom the services are performed wants them done in a particular method or manner.
- Integration. Integrating the worker’s services into the business operations generally shows that he or she is subject to direction and control. When the success or continuation of a business depends to an appreciable degree on the performance of certain services, the workers who do them must necessarily be subject to a certain amount of control by the business owner.
- Services rendered personally. If the worker must render the services personally, presumably the person for whom they are performed is interested in the methods used to accomplish the work as well as in the results.
- Hiring, supervising and paying assistants. If the person for whom the services are performed hires, supervises and pays assistants, that generally shows control over the workers on the job. However, if one worker hires, supervises and pays the other assistants under a contract in which the worker agrees to provide materials and labor and is responsible only for attaining a result, this indicates independent contractor status.
- Continuing relationship. A continuing relationship between the worker and the person for whom the services are performed indicates an employer-employee relationship exists. This may occur when work is performed at frequently recurring although irregular intervals.
- Set hours of work. If the person for whom the services are performed establishes set work hours, this indicates control.
- Full-time required. If the worker must devote himself or herself substantially full-time to the business of the person for whom the services are performed, the latter has control over the amount of time the worker spends working and implicitly restricts the worker from doing other gainful work. An independent contractor, on the other hand, is free to work when and for whom he or she chooses.
- Doing work on employer’s premises. If the individual performs the work on the premises of the person for whom the services are performed, this suggests control over the worker, especially if the work could be done elsewhere. Work done off the premises, such as at the worker’s office, indicates some freedom from control. However, this fact by itself does not mean the worker is not an employee. The importance of this factor depends on the nature of the service involved and the extent to which an employer generally would require that employees perform such services on the premises. Control over the place of work is indicated when the person for whom the services are performed has the right to compel the worker to travel a designated route, to canvass a territory within a certain time frame or work at specific places.
- Order or sequence set. If a worker must perform services in the order or sequence set by the person for whom the services are performed, that factor shows the worker is not free to follow his or her own pattern of work but must follow the established routines and schedules of the employer. Often, because of the nature of an occupation, the person or persons for whom the services are performed do not set the order of the services or set it infrequently. Retaining the right to do so is sufficient to show control.
- Oral or written reports. A requirement that the worker submit regular or written reports to the person or persons for whom the services are performed indicates a certain degree of control.
- Payment by hour, week or month. Payment by one of these three methods generally points to an employer-employee relationship, provided this method is not just a convenient way of paying a lump sum agreed upon as the cost of a job. Payment made by the job or on a straight commission basis generally indicates the worker is an independent contractor.
- Payment of business or travel expenses. If the person for whom the services are performed generally pays the worker’s business and travel expenses, he or she is ordinarily an employee. To control expenses, an employer usually retains the right to regulate and direct the worker’s business activities.
- Tools and materials. The fact the person for whom the services are performed furnishes significant tools, materials and other equipment tends to show the existence of an employer-employee relationship.
- Significant investment. If the worker invests in facilities not typically maintained by employees (such as an office rented at fair value from an unrelated party) and uses them to perform services, that tends to indicate the worker is an independent contractor. On the other hand, lack of investment in facilities indicates dependence on the person for whom the services are performed for such facilities. Accordingly, an employer-employee relationship exists.
- Realization of profit or loss. A worker who can realize a profit or suffer a loss as a result of his or her services (in addition to the profit or loss ordinarily realized by employees) is generally an independent contractor. The worker who cannot is an employee. For example, if a worker is subject to a real risk of economic loss due to a significant investment or a bona fide liability for expenses, such as salary payments to unrelated employees, that indicates the worker is an independent contractor. The risk a worker will not receive payment for his or her services, however, is common to both independent contractors and employees and thus is not sufficient to support independent contractor treatment.
- Working for more than one entity. If a worker performs more than de minimis services for multiple unrelated persons or companies at the same time, that factor generally indicates the worker is an independent contractor. However, a worker who performs services for more than one person may be an employee of each, especially where the two are connected.
- Making service available to the general public. The fact a worker makes his or her services available to the general public on a regular and consistent basis indicates an independent contractor relationship.
- Right to discharge. The right to fire a worker is a factor indicating the worker is an employee and the person with the right is an employer. An employer exercises control through the threat of dismissal, which causes the worker to obey the employer’s instructions. An independent contractor, on the other hand, cannot be fired so long as he or she produces a result that meets the agreed contract specifications.
- Right to terminate. If the worker has the right to end his or her relationship with the person for whom the services are performed at any time without incurring liability, this indicates an employer-employee relationship.
Employee or Independent Contractor?
Whether someone who works for you is an employee or an independent contractor is an important question. The answer determines your liability to pay and withhold Federal income tax, social security and Medicare taxes, and Federal unemployment tax.
In general, someone who performs services for you is your employee if you can control what will be done and how it will be done.
The courts have considered many facts in deciding whether a worker is an independent contractor or an employee. These facts fall into three main categories:
Behavioral Control – Facts that show whether the business has a right to direct and control. These include:
Instructions – an employee is generally told:
- when, where, and how to 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
Training – an employee may be trained to perform services in a particular manner.
Financial Control – Facts that show whether the business has a right to control the business aspects of the worker’s job include:
- The extent to which the worker has unreimbursed expenses
- The extent of the worker’s investment
- The extent to which the worker makes services available to the relevant market
- How the business pays the worker
- The extent to which the worker can realize a profit or loss
Type of Relationship – Facts that show the type of relationship include:
- Written contracts describing the relationship the parties intended to create
- Whether the worker is provided with employee-type benefits
- The permanency of the relationship
- How integral the services are to the principal activity
For a worker who is considered your employee, you are responsible for:
- Withholding Federal income tax,
- Withholding and paying the employer social security and Medicare tax,
- Paying Federal unemployment tax (FUTA)
- Issuing Form W-2, Wage and Tax Statement, annually,
- Reporting wages on Form 941, Employer’s Quarterly Federal Tax Return.
For a worker who is considered an independent contractor, you may be responsible for issuing Form 1099-MISC, Miscellaneous Income, to report compensation paid.
The status of certain workers is specifically determined by law; these workers are known as statutory employees and statutory non-employees. See Publication 15-A, Employer’s Supplemental Tax Guide, for more information.
If you would like for the IRS to determine whether or not a worker is considered an employee, please submit Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
Employees vs. Independent Contractors
The tax law covering independent contractors is very complicated. Before you can determine how to treat payments you make for services, you must first know the business relationship that exists between you and the person performing the services. The person performing the services may be –
- An independent contractor
- A common-law employee (Employee)
- A statutory employee
- A statutory nonemployee
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.
It is critical that you, the employer, correctly determine whether the individuals providing services are employees or independent contractors. Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors.
Caution: If you incorrectly classify an employee as an independent contractor, you can be held liable for employment taxes for that worker, plus a penalty.
Who is an Independent Contractor?
A general rule is that you, the payer, have the right to control or direct only the result of the work done by an independent contractor, and not the means and methods of accomplishing the result.
Example: Vera Elm, an electrician, submitted a job estimate to a housing complex for electrical work at $16 per hour for 400 hours. She is to receive $1,280 every 2 weeks for the next 10 weeks. This is not considered payment by the hour. Even if she works more or less than 400 hours to complete the work, Vera Elm will receive $6,400. She also performs additional electrical installations under contracts with other companies, that she obtained through advertisements. Vera is an independent contractor.
Example: Steve Smith, a computer programmer, is laid off when Megabyte Inc. downsizes. Megabyte agrees to pay Steve a flat amount to complete a one-time project to create a certain product. It is not clear how long it will take to complete the project, and Steve is not guaranteed any minimum payment for the hours spent on the program. Megabyte provides Steve with no instructions beyond the specification for the product itself. Steve and Megabyte have a written contract, which provides that Steve is considered to be an independent contractor, is required to pay Federal and state taxes, and receives no benefits from Megabyte. Megabyte will file a Form 1099-MISC (PDF). Steve does the work on a new high-end computer which cost him $7000. Steve works at home and is not expected or allowed to attend meetings of the software development group. Steve is an independent contractor.
Refer to the page on Paying Independent Contractor if you need information on what your responsibilities are when paying contractors.
How should I report payments made to independent contractors?
You may be required to file information returns to report certain types of payments made to independent contractors during the year. For example, you must file Form 1099-MISC, Miscellaneous Income, to report payments of $600 or more to persons not treated as employees (e.g. independent contractors) for services performed for your trade or business. For details about filing Form 1099 and for information about required electronic or magnetic media filing, refer to information returns.
Who is a Common-Law Employees (Employee)?
Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.
To determine whether an individual is an employee or independent contractor under the common law, the relationship of the worker and the business must be examined. All evidence of control and independence must be considered. In an employee-independent contractor determination, all information that provides evidence of the degree of control and degree of independence must be considered.
Facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties. Refer to Publication 15-A, Employer’s Supplemental Tax Guide for additional information.
Tax Topic 762 Basic Information
To determine whether a worker is an independent contractor or an employee, you must examine the relationship between the worker and the business. All evidence of control and independence in this relationship should be considered. The facts that provide this evidence fall into three categories Behavioral Control, Financial Control, and the Type of Relationship itself.
Publication 1976, Section 530 Employment Tax Relief Requirements
Section 530 provides businesses with relief from Federal employment tax obligations if certain requirements are met.
IRS Internal Training: Employee/Independent Contractor
This manual provides you with the tools to make correct determinations of worker classifications. It discusses facts that may indicate the existence of an independent contractor or an employer-employee relationship. This training manual is a guide and is not legally binding. If you would like the IRS to make the determination of worker status, please file IRS Form SS-8.
Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding
The Employer’s Supplemental Tax Guide has detailed guidance including information for specific industries.
The Employer’s Tax Guide to Fringe Benefits supplements Circular E (Pub. 15), Employer’s Tax Guide, and Publication 15-A, Employer’s Supplemental Tax Guide. It contains specialized and detailed information on the employment tax treatment of fringe benefits.
Who is an Employee?
A general rule is that anyone who performs services for you is your employee if you can control what will be done and how it will be done.
Example: Donna Lee is a salesperson employed on a full-time basis by Bob Blue, an auto dealer. She works 6 days a week, and is on duty in Bob’s showroom on certain assigned days and times. She appraises trade-ins, but her appraisals are subject to the sales manager’s approval. Lists of prospective customers belong to the dealer. She has to develop leads and report results to the sales manager. Because of her experience, she requires only minimal assistance in closing and financing sales and in other phases of her work. She is paid a commission and is eligible for prizes and bonuses offered by Bob. Bob also pays the cost of health insurance and group-term life insurance for Donna. Donna is an employee of Bob Blue.
If workers are independent contractors under the common law rules, such workers may nevertheless be treated as employees by statute ( statutory employees ) for certain employment tax purposes if they fall within any one of the following four categories and meet the three conditions described under Social security and Medicare taxes , below.
A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.
A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.
An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done.
A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer s business operation. The work performed for you must be the salesperson s principal business activity. Refer to the Salesperson section located in Publication 15-A, Employer s Supplemental Tax Guide for additional information.
There are two categories of statutory nonemployees: direct sellers and licensed real estate agents. They are treated as self-employed for all Federal tax purposes, including income and employment taxes, if:
Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked and
Their services are performed under a written contract providing that they will not be treated as employees for Federal tax purposes.
Refer to information on Direct Sellers located in Publication 15-A, Employer s Supplemental Tax Guide for additional information.
Misclassification of Employees
Consequences of treating an employee as an independent contractor. If you classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker. See Internal Revenue Code section 3509 for additional information.
Professional Employer Organization (PEO)
A Professional Employer Organization (PEO) is a dedicated HR management and benefits administration partner through a co-employment or employee leasing model.
In a standard Professional Employer Organization, you retain the day-to-day control over how you manage your employees, and your provider handles the HR management and benefits administration.
Certified Professional Employer Organization
HR 5771 that was enacted into law creating the Certified Professional Employer Organization https://www.congress.gov/bill/113th-congress/house-bill/5771/text?overview=closed
d. Special Rules for Form 941
If less than the correct amount of tax imposed under the Federal Insurance Contributions Act (FICA), the Railroad Retirement Tax Act (RRTA), or the income tax withholding provisions is collected from the employee or paid to the IRS with respect to any payment of wages or compensation, the Code allows correction (adjustment) and payment of both the tax and the deductible amount to be made, without interest, in accordance with applicable Treasury regulations. 413 Under this procedure, where the employer ascertains the error after the employment tax return for the applicable period is filed, the employer: (1) reports the amount of underpayment as an adjustment on a return filed on or before the day on which the return is required to be filed for the return period for which the error is discovered, and (2) pays each amount of underpayment reported as an adjustment to the IRS, without interest, no later than the date on which the return reporting the adjustment is required to be filed. If the adjustment is timely reported but the underpayment is not paid when due, interest will accrue from the due date of the return on which the adjustment is reported. 414 The employer is not entitled to the interest-free adjustment where it knowingly underreports its employment tax liability 415 or disregards facts with the knowledge that further inquiry would likely result in discovery of an error. 416
/Footnote/ 413 §6205(a)(1).
/Footnote/ 414 Prop. Regs. §31.6205-1. When an employer discovers, before filing a return, that it failed to withhold income tax or the employee portion of the FICA taxes, the reporting and payment by the employer of the correct amount of tax do not technically qualify for an interest-free adjustment. However, no interest is due because interest on the underpayment of income and FICA taxes required to be withheld by an employer does not begin to run until the due date of the return for the period in which the withholding was required. Cf.TAM 9552003 (Company liable for interest on backup withholding tax liability where notice and demand for payment of tax due made before filing supplemental return and interest-free adjustment provisions of §6205 do not apply).
/Footnote/ 415 Rev. Rul. 75-464, 1975-2 C.B. 474. See also TAMs 9602003, 9602004 (Corporation knowingly underreported employment tax liability).
/Footnote/ 416 Rev. Rul. 86-10, 1986-1 C.B. 358.
Example-Interest-Free Adjustment Procedure
Employer E filed a Form 941 on July 31, 2002, for the second quarter of 2002 but inadvertently failed to report $5,000 of an employee’s wages. On Oct. 20, 2002, while preparing Form 941 for the third quarter of 2002, E discovers the error. E may avoid interest on the tax on the $5,000 if E both corrects the error and pays the tax on or before the last day permitted for filing a return for the quarter in which the error was discovered, in this case, Jan. 31, 2003. E corrects the error by making an adjustment on Form 941 for either the third quarter (which E is currently preparing) or the fourth quarter and attaching Form 941C, Supporting Statement to Correct Information.
Another situation where the interest-free adjustment procedure may apply is if an employer fails to file a return for a period solely because it improperly failed to treat any individuals as employees for the period (and, therefore, failed to pay any employer or employee tax under FICA or the RRTA, or failed to pay any income tax required to be withheld). 417 Here, the employer must also file a return for the period and report on the return and pay to the IRS the correct amount of tax. With respect to errors discovered after December 31, 1991, the reporting and payment by the employer of the correct amount of tax for the period is an adjustment without interest only if the return is filed and the tax is paid no later than the due date of a like return for the return period in which the erroneous nonpayment was discovered. In this case, the employer should file an original return (either Form 941 or Form CT-1) for each period for which the employer erroneously failed to file a return and should write “Misclassified Employees” in the top margin of each return. 418
/Footnote/ 417 Interest-free adjustments cannot be made after the employer receives a Notice of Determination Concerning Worker Classification Under Section 7436. Regs. §31.6205-1(a)(6).
/Footnote/ 418 Prop. Regs. §31.6205-1(b)(2), (c)(2).
The authority given to employers under the regulations 418.1 to make additional deductions from employee wages to correct withholding errors only applies to such underwithheld taxes in years where the statute of limitations is still open. 418.2
/Footnote/ 418.1 Regs. §31.6205-1(b)(3).
/Footnote/ 418.2 FSA 200134001.