Classifying workers can be a tricky situation
Business owners often ask for guidance on compensation issues including how to pay their people. Run employee W-2 payroll or pay as an independent contractor with a 1099. A simple choice or so it seems. However, many enter the conversation with the preconceived notion that independent contractor vs employee status is a simple choice which is far from the truth, let’s dig in.
Business Risk
What could go wrong? 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. Employment taxes include Social Security, Medicare, and unemployment taxes which can exceed 15% of compensation.
How would you feel if you received an unexpected bill from the IRS for 15% of your independent contractor’s pay for a year or years?
Common Law Tests
When unsure of employee or independent contractor status we guide employers through the common law tests. All facts and circumstances should be considered and no single factor is conclusive.
- the right to exercise control over the details of the work <– this is the most important test
- which party invests in the facilities used in the work
- the opportunity of the worker for profit or loss
- whether or not the principal has the right to discharge the worker
- whether the work is part of the principal’s regular business
- the permanency of the relationship
- the relationship the parties believe they are creating
As you ask yourself these questions and think about your people the more they look like an employee the more likely they should be classified as such. The more they look like they are running their own business with your business as a customer the more likely they should be classified as an independent contractor.
Want to learn more? Take a look at guidance from IRS on Independent Contractor vs Employee. There is a longer 20-factor test the IRS may use for determining whether a worker is an employee or independent contractor as well as a group of statutorily defined employees and independent contractors (non-employees).
Real World Example — Cleaners were independent contractors, not employees
Last month the US Tax Court ruled in favor Ms. Santos, an entrepreneur and owner of a cleaning business that serviced apartment complexes. The IRS asserted that her cleaners were employees not independent contractors and demanded federal employment taxes for 2008, 2009, and 2010. Ms. Santos challenged the IRS determination and won.
According to the Tax Court, Santos’ role was more that of a dispatcher than an employer, acting as a financial and linguistic bridge or intermediary between the workers and the apartment complexes.
The Tax Court agreed that Santos did not control her workers in a manner that would establish an employer-employee relationship because she did not have the right to control the manner and means by which the cleaning work would be accomplished.
The Tax Court also found that Santos’ workers did not have to take any cleaning job she offered them; and when they did take a job, they by and large traveled to the apartment complexes using their own or public transportation and performed the job at their own pace using the cleaning supplies that they brought with them to the job.
The Tax Court noted that while the apartment cleaning contracts obligated Santos’ business to maintain commercial general liability insurance and worker’s compensation insurance, this was not definitive evidence that Santos had the requisite degree of control over the workers. The contracts governed only the relationship between Santos and the apartment complexes; they had no legal bearing on Santos’ relationship with her workers.
Finally, Santos’ issuance of Forms 1099-MISC, rather than Forms W-2, indicated that she thought that her workers were independent contractors and not employees.
Tax Compliance Considerations Matrix
| Employee | Independent Contractor | |
|---|---|---|
| Onboarding | IRS Form W-4 | IRS Form W-9 |
| Compensation | Payroll / Wages | Invoice & Payment like every other vendor |
| Benefits | Allowable | None, Self-Employed |
| Payroll Taxes | Paid by Employer* | Independent Contractors are responsible for their own taxes |
| Income Tax Withholding | Employer withholds and remits | Independent Contractor is responsible and often makes quarterly estimated tax payments |
| Information Reporting | W-2/940/941 | 1099-NEC (previously reported on 1099-MISC) |
Partnering with an experienced firm can help you navigate complex classification processes and procedures. Human resources, legal, insurance and other differences in classification should also be considered.
Protect your organization
At Proseer we guide entrepreneurs and high net worth families through the intricacies of taxes and accounting. If you have questions about how to structure employment or independent contractor compensation please contact us.
