Many companies these days are making use of contract labor in lieu of full-time (or even part-time) employees for a lot of good reasons: specific job skills may be required only for an identifiable project or for a short period of time; more personnel may be required to carry the company through a particularly busy period; the company may not be sufficiently financially secure to attract the talent it needs on an employer–employee basis but may be able to successfully “contract” labor for a specified period of time. Whatever the reason, the use of contract labor is common among companies of all types and sizes and its use is growing.
With the increase in usage of contract labor has come increased attention to the subject by the Internal Revenue Service and the various state employment departments. They are viewing the increased usage of contract labor with suspicion and fear that companies are using contract labor for a different, more subversive reason: to avoid the withholding and payment of payroll taxes. So be careful, one man’s contract laborer is often another man’s employee.
What difference does it make if I classify a worker as an independent contractor instead of as an employee?
Employers are responsible for the withholding and timely remittance of federal income taxes, state and local income taxes, and FICA taxes from wages paid to their employees.
Employer Payroll Taxes
Employers owe, and must remit, their own share of payroll taxes, such as FICA and federal and state unemployment insurance, on employee wages.
Worker’s compensation, working condition, and minimum wage laws all impose on employers certain financial and other requirements for the benefit of employees.
Employees generally enjoy employer funded benefit programs such as vacations, holidays with pay, health insurance, and pension and profit sharing plans; contractors generally do not receive these benefits.
Wages paid to employees (along with the amounts of the various taxes withheld) are reported on Form W-2; amounts paid to contractors are reported on Form 1099. Additionally, Forms 940 and 941 (and perhaps others) must be filed for wages paid to employees.
And all of this is just for right now. Your friend, the General Accounting Office (GAO), thinks you should also withhold payroll taxes on payments to contractors to avoid underreporting of income by these untrustworthy individuals. The GAO also thinks the current $50 penalty for failure to file Forms 1099 should be boosted, that the current threshold of $600 for filing Forms 1099 should be lowered, that total payments to independent contractors during a year should be reported on your Form 1120, that incorporated independent contractors should be added to the list of those for whom Forms 1099 must be filed, and that contractors’ tax identification numbers should be obtained and validated before you make any payments to those contractors.
OK, so it does make a difference. How can I determine whether a particular worker is an employee or an independent contractor?
Not only may one man’s contract laborer be another man’s employee—one federal agency’s contract laborer may be another agency’s employee!
Federal Income Tax (FIT) Treatment.
Two classes of workers (direct sellers and licensed, qualified real estate agents) are specifically classified as independent contractors by the Internal Revenue Code. The status of other classes of workers is determined through application of the Common Law test discussed below.
Federal Insurance Contributions Act (FICA) Treatment. FICA specifically classifies five types of workers as employees: corporate officers, agent drivers or commission drivers who distribute food or beverages or handle laundry or dry cleaning, industrial home workers who receive at least $100 in a calendar year, full time life insurance salespeople, and full time traveling or city salespeople who solicit orders from retail merchants for later delivery. Others are classified through application of the Common Law test.
Federal Unemployment Tax Act (FUTA) Treatment. FUTA’s specified employees are corporate officers, agent drivers or commission drivers, and traveling or city salespeople. Others are classified through application of the Common Law test.
(Keep in mind that the classification of a worker as an employee or contractor through application of the above rules does not automatically mean that FIT, FICA, or FUTA is due and payable. Making those determinations requires analysis of the various definitions of taxable and exempt wages.)
Common Law Test.
Applying the Common Law test to determine whether a worker is an employee or contractor basically consists of analyzing the level of control you, as an employer, exert over the worker. The more control you possess (especially over the means of accomplishing a task rather than the end result), the more likely a worker is an employee. Control, in this instance, is defined as the level of legal right to direct rather than the level of direction actually provided.
The IRS uses a twenty question test to assess the level of control (“yes” answers provide evidence of an employer–employee relationship):
- Is the worker required to follow your instructions in completing the job or accomplishing the task?
- Do you provide the training necessary for completion of the job?
- Are the worker’s specific personal services required for successful completion of the job?
- Are the worker’s services crucial to the success or continued existence of your company?
- Do you set work hours?
- Does the worker have a continuing relationship with your company?
- Do you hire, supervise, or pay any of the worker’s assistants?
- Is the worker precluded from seeking assignments with other companies or from refusing assignments offered by your company?
- Do you specify the location where the work must be performed?
- Do you direct the order or sequence of tasks to be performed?
- Do you require progress reports?
- Is the worker paid by the hour, week, or month, rather than for the completion (or stage of completion) of the project?
- Does the worker work only for your company?
- Do you pay business overhead and incidental expenses?
- Do you provide equipment, tools, and materials?
- Is the work performed on your premises or using your facilities?
- Are the worker’s services not available to the general public?
- Do you provide a minimum “salary” and therefore shield the worker from the risk of profit or loss on the job?
- Do you have the right to terminate the worker even if the job results are achieved?
- Are you required to pay the worker for time spent even if the job is not completed?
Honest answers to the above questions will help you to determine whether a worker is a contractor or an employee. Remember that job title, designation as a “contractor” within the “contract,” or the degree of freedom enjoyed by the worker have no bearing on the level of your control and therefore no weight in the determination of status.
Safe Harbor Rules
The safe harbor rules provide some relief against the classification of a worker as an employee. A worker will not be deemed to be an employee (even if the Common Law test concludes otherwise) if: (1) you never treated the worker (or other workers holding substantially similar positions) as an employee for employment tax purposes; (2) you filed all employment tax and information returns consistent with the worker’s classification as a contractor; and (3) a “reasonable basis” for treating the worker as a contractor exists.
“Reasonable basis” safe havens include: (1) judicial precedent, published rulings, technical advice, and letter rulings; (2) results of past IRS audit that did not classify workers holding substantially similar positions as employees; and (3) longstanding and recognized industry practice.
As with any issue before the IRS, special rules apply to all sorts of worker groups including, but not limited to, accountants, agricultural labor, attorneys, casual labor, corporate directors and officers, domestics, family members, insurance agents, military, ministers, partners, physicians and dentists, and students. Check the specific rules if you are using these types of workers.
Wow, this is really complicated. What if I can’t figure out whether I have an employee or a contractor?
If, after applying the Common Law test, you are unable to determine a worker’s status, you may request a specific IRS determination by filing Form SS-8 with the district director of your IRS service center.
OK, so maybe I really do have an employee. But, all those taxes and forms, and the job is only temporary — what’s the problem with treating this worker as an independent contractor anyway?
Call the worker whatever you want but, for tax purposes, treat him (her) as an employee! The IRS and the various state agencies may hit you with back taxes, interest, and penalties. They may even try to charge you with fraud. If the taxing authorities decide the worker was an employee, the worker may come back to you with claims for wages, overtime, and employee benefits.
Of course, to avoid all of this, you could just get your workers from an employee leasing company . . . or can you? Beware even in this instance — you may bear the final responsibility for any unpaid payroll taxes (for instance, if the leasing company goes out of business). You may also be determined to be the actual employer if you set salaries, choose employees, or fire employees.
Using contract labor may still be the financially prudent choice for your company. Just make sure that you do not get caught in a definitional trap.
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