- Learn how to distinguish an employee from an independent contractor.
- Find information regarding state legislation and federal guidelines.
- Can business partners be employees?
- Learn about the advantages of independent contractor status.
- Find information about Form SS-8 and when to use it.
- Learn about SE Tax.
- Discover information about Form 8919.
- Learn about the penalties for misclassifying workers.
- Find information about the IRS’ Voluntary Classification Settlement Program.
It is not uncommon for employers to misclassify employees as independent contractors. They may either intentionally avoid their withholding and tax responsibilities, or they are not aware of the laws regarding the issue. Misclassifying a worker can have significant ramifications for both the employer and the worker in terms of how much each pays in income, Social Security, and Medicare taxes, among others. Worker misclassification is a perennial issue for the Internal Revenue Service and state taxing authorities due to the perception that many employers are not correctly classifying their workers. This article looks at several issues regarding the independent contractor vs. the employee.
Employee or Independent Contractor?
The general distinction is that an employee is an individual who works under the direction and control of an employer. An independent contractor is a self-employed business owner who provides services to others.
Both federal law and state law govern whether an individual is an employee or an independent contractor. It has always been a complicated issue at both the federal and state levels. The state and federal guidelines also often differ. However, because of the significant payroll tax revenues involved, the states are generally more aggressive in classifying workers as employees.
The ABC Test
In recent years several states, including California, Massachusetts, and New Jersey, have adopted the so-called ABC test. This test is a broad means of determining a worker’s status as either an employee or a contractor by considering three factors. If a worker passes all three, then he or she is an independent contractor. The tests are:
(A) That the worker is free from the hirer’s control and direction, in connection with the performance of the work, both under the contract for the performance of such work and in fact;
(B) That the worker performs work outside the usual course of the hiring entity’s business; and
(C) That the worker customarily engages in an independently established trade, occupation, or business of the exact nature as the work performed for the hiring entity.
Control and Independence in the Worker-Business Relationship
To determine whether a worker is an independent contractor or an employee, the IRS examines the relationship between the worker and the business. They then consider all evidence regarding control and independence.
3 Categories of Evidence
This evidence falls into the following three categories:
(1) Behavioral control covers whether the business retains the right to direct or control how the worker does the work through instructions, training, or other means. Employees generally receive instructions on when and where to work, what tools to use, where to purchase supplies, what order to follow, and so on.
(2) Financial control covers whether the business has the right to control the financial and business aspects of the worker’s job. This includes the extent to which the worker has unreimbursed business expenses; the extent of his or her investment in the tools, equipment, and facilities used; the extent to which his or her services are made available to the relevant market; how he or she receives payment; and the extent to which he or she can realize a profit or incur a loss.
(3) Type of relationship includes any written contracts that describe the relationship the parties intended to create; the extent to which the worker is available to perform services for other, similar businesses; whether the business provides the worker with employee-type benefits, such as insurance, a retirement plan, vacation pay, or sick pay; the permanency of the relationship; and the extent to which the worker’s services are a key aspect of the company’s regular business.
If the business has the right to not only control or direct the work but also how the work is done, then the workers are most likely employees. On the other hand, if the company can direct or control only the result of the work done, and not the means and methods of accomplishing the result, then the workers are probably independent contractors.
One situation in which there is no uncertainty as to classification relates to a partner in a partnership. The IRS has long held that a bona fide member of a partnership is not an employee of the partnership. Also, a partner who devotes time and energy to conducting the partnership's trade or business, or who provides services to the partnership as an independent contractor, is considered self-employed and is not an employee.
Advantages of Independent Contractors
The obvious advantages for a business to treat an individual as an independent contractor are to avoid paying minimum wages, overtime, payroll taxes, worker’s compensation insurance, unemployment tax, Social Security and Medicare contributions, health benefits, paid leave, 401(k) contributions, and unpaid leave under the Federal Family and Medical Leave Act.
Workers also have some tax-related benefits when considered independent contractors. These benefits include the ability to deduct certain business expenses not available to employees, the eligibility to set up their retirement plans, and the fact that they are not subject to withholding. Of course, many workers want to be considered employees so they can receive the benefits available to employees, such as vacation pay, overtime pay, and health insurance coverage.
When the IRS Decides a Worker’s Status
When a worker’s status is in doubt, Form SS-8 (Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding) can be used. An employer or a worker may complete this form; it asks the IRS to determine whether the worker is an employee or an independent contractor for federal tax purposes. Requestors file Form SS-8 separately from their tax return. The IRS does not issue determinations for proposed employment arrangements or hypothetical situations. It will only issue a determination if the statute of limitations for the year at issue hasn’t expired.
An independent contractor will need to pay self-employment (SE) tax on their net self-employment earnings. The SE tax is the individual’s Social Security and Medicare tax contributions. For an employee, the employer pays half of these taxes and the employee pays the other half through their payroll withholding. A self-employed individual pays 100% of these taxes with their 1040 return using Schedule SE. A self-employed individual will not have income tax withheld from the income they receive as an independent contractor. They will usually need to make estimated tax payments during the year to cover their income and SE tax liabilities.
If an individual has filed Form SS-8 and the IRS has determined their status as an employee, or if an individual believes he or she was misclassified as an independent contractor and wants to avoid paying self-employment tax on 1099-NEC or 1099-MISC income – or when he or she has filed an SS-8 but has not received a response – that individual can file Form 8919, which only requires payment of what would have been withheld if the worker had been treated as an employee. Form 8919 requires the employee to choose one of these codes:
Code A. I filed Form SS-8 and received a determination letter stating that I am an employee of this firm.
Code C. I received other correspondence from the IRS that states I am an employee.
Code G. I filed Form SS-8 with the IRS but have not received a reply.
Code H. I received a Form W-2 and a 1099-NEC or 1099-MISC from this firm for the same tax year. The amount on Form 1099-NEC or 1099-MISC should have been included as wages on Form W-2.
Using the Codes
If using Code H, an SS-8 should not be filed. Here are some examples of amounts sometimes erroneously included (but not necessarily deliberately misclassified) on Form 1099-NEC or 1099-MISC and that should have been reported as wages on Form W-2: employee bonuses, awards, travel expense reimbursements not paid under an accountable plan, scholarships, and signing bonuses.
If Code G on Form 8819 is used, both the worker and the firm that paid the worker may be contacted for additional information. Use of this code is not a guarantee that the IRS will agree with the worker’s opinion as to his or her status. What if the IRS does not agree that the worker is an employee? The worker may be billed an additional amount for the employment tax. They may also have to pay penalties and interest resulting from the change in the worker’s status.
What if the IRS determination is for multiple open years? The employee can amend returns for open years to recover a portion of the self-employment tax paid.
Penalties for Misclassification of an Employee as an Independent Contractor
A business that misclassifies an employee can be held liable for employment taxes for that worker. They may also owe various penalties. If the employer willfully misclassified the individual, additional penalties apply and possibly prison time. The state could pile on more penalties where the business operates and the misclassified employee could receive back wages for overtime, mandated work breaks, retirement benefits, and more. Misclassifying a worker can be very costly to the employer.
The IRS offers an optional Voluntary Classification Settlement Program that allows businesses to reclassify their workers as employees for future employment tax purposes and offers partial relief from federal employment taxes for eligible businesses who agree to prospectively treat their workers as employees. Businesses must meet specific eligibility requirements and apply by filing Form 8952, Application for Voluntary Classification Settlement Program (VCSP), and enter into a closing agreement with the IRS.