Employee or Independent Contractor? It Makes a Big Tax Difference

Jun 7th 2017
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Here’s a question virtually every small business owner should ask themselves: Are my workers employees or independent contractors? It can make a big tax difference, but there’s no definitive answer. It all depends on the particular facts and circumstances of the business.

The IRS remains concerned that workers are being misclassified. The agency recently reminded small business owners of the basic guidelines for determining the employment status of workers.

For starters, your small business clients should know and understand the potential tax ramifications. If a worker is classified as an employee, the employer must withhold federal income tax and the employee’s share of FICA tax (including Social Security and Medicare taxes) from pay.

What’s more, the employer must pay its share of the FICA tax and federal unemployment tax (FUTA). Finally, the employer is required to issue a Form W-2 to its employees showing the wages paid and send a copy to the IRS.

Conversely, if a worker qualifies as an independent contractor, the employer is off the hook for the federal income tax withholding, FICA, and FUTA. And the business doesn’t have to offer the worker expensive fringe benefits, like health insurance and matching contributions to a 401(k) plan. For these reasons, employers often prefer to classify workers as independent contractors rather than employees.

The IRS reminded small business owners to keep in mind two key points when it comes to classifying workers:

1. Control. The relationship between a worker and a business is important. If the business controls what work is accomplished and directs how it is done, it exerts behavioral control. If the business directs or controls financial and certain relevant aspects of a worker’s job, it exercises financial control.

This includes:

  • The extent of the worker’s investment in the facilities or tools used in performing services.
  • The extent to which the worker makes his or her services available to the relevant market.
  • How the business pays the worker.
  • The extent to which the worker can realize a profit or incur a loss.

2. Relationship. How the employer and worker perceive their relationship is also critical for determining worker status. Some of the key topics to think about include:

  • Written contracts describing the relationship the parties intended to create.
  • Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation, or sick pay.
  • The permanency of the relationship.
  • The extent to which services performed by the worker are a key aspect of the regular business of the company.
  • The extent to which the worker has unreimbursed business expenses.

Finally, clients should be made aware that the stakes are high. If the IRS says a worker has been misclassified as an independent contractor, the employer could be hit with a huge tax bill for unpaid employment taxes, plus interest and penalties.

Contact your clients about their specific situations and encourage them to seek your guidance on close calls. 

Related articles:

The Tale of the Misclassified Worker
Employee or Contractor? An In-Depth Look at Uber and Lyft

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