Rules to Correctly Identify
One of the most essential questions that a business needs to be able to answer with confidence is how they should define an individual that is providing services to the organization. There are several different ways that a business relationship can be defined. The person providing work may be an employee or an independent contractor. They may also be categorized as a statutory employee or a statutory non-employee.
Correctly identifying what the relationship is will guide you in the way that you handle the payments that you make to the person, and (more importantly) what your obligations are in terms of your tax liabilities. Making the correct identification relies on the information available regarding how much control you exert over the person’s work, and how independently they operate. It is this information that the IRS will use as evidence to ensure that you are providing the correct answer.
Common Law Rules
There are three specific categories that the IRS uses to determine whether a person is an independent contractor or is an employee, and which taken together will help you to determine exactly how independent the person that is working for you is. These three categories are behavioral, financial and type of relationship.
Behavioral – This refers to the degree to which the company providing payment controls the method by which the work is being done for them, or what the person providing the work is doing. Do you make all of the decisions as to what is being done and how it is to be executed, or do they?
Financial – This refers to the extent to which the company providing payment controls financial considerations of the work, including how and when the worker is provided with payment, whether they receive compensation for expenses related to their work, whether their supplies are provided to them or whether they are responsible for providing their own tools, materials and supplies. Are you paying the person out of payroll or are they submitting bills?
Type of Relationship – This refers to contractual aspects of the relationship between the company providing payment and the worker, and may include the existence of benefits that are being paid to them (such as vacation time, 401K, sick leave). It also includes the duration of the relationship – in other words, is the relationship completed once a project is done, or is the person being paid to provide an ongoing and key service for the company?
The answers to each of these questions must be care addressed and considered, as it is their answer that determines whether the person is to be categorized as an independent contractor or as an employee of the business. The answer can be straightforward and simple or it can be complex, and made even more challenging by the fact that no one of these categories has primacy, and there is no clear-cut line after which a certain number of “yes” answers provides a specific answer. What may be true for one business may be different for another.
What the government expects is for a holistic view to be taken of the situation in order to answer exactly how much control and direction they provide, and whether it is enough to classify the person providing the work as independent or not.
Liability for Taxes
The reason that it is so important to get the answer to this question right is that a worker’s employment status determines what the business’ tax liability is. If the person providing the work is considered an employee of the business, then the company is required to submit unemployment taxes on both a state and federal level, as well as to pay premiums for workers’ compensation and disability insurance and social security taxes. By contrast, if the individual providing the work is an independent contractor, then the company has no such obligation.
Getting the answer wrong has serious implications. Companies that classify employees as independent contractors can find themselves faced with back taxes and penalties for both unpaid federal unemployment taxes and unpaid FICA liabilities.
The good news for businesses is that there are certain safe harbors available that make it possible to avoid these penalties. These allowances provide the ability to categorize a worker as an independent contractor based on specific factors. These include having had workers providing similar work in the past who were able to be identified as independent contractors, and having already been audited in the past and having had similar working arrangements without having been charged with wrongdoing or having to pay any penalties.
Though the common law questions provide some room for interpretation, there are specific situations where there is no question as to whether an individual providing work is an employee or an independent contractor. A worker is always considered to be an independent contractor if the following factors exist:
- They are able to work at their own pace based upon an existing agreement
- The company providing payment for the work is not their only source of income
- The worker is not eligible for any type of benefits from the company
- They maintain independence and a degree of control over their work
Though it is to be expected that arrangements such as an oral or written contract between a company and an independent contractor will outline work requirements and specifications, those in no way stop the independent contractor from being self-directed.
By contrast, an employee has no such ability. By virtue of working for another they are reliant upon the company for their income and must submit to the direction of their employer. In exchange for submitting to company control and giving up their independence to the requirements of the work environment, they receive employee benefits.
Knowing whether a person providing work to your company is an employee or an independent contractor is an important responsibility, and it is important that you get the answer right in order to shield yourself from penalties in the future. For help addressing this and other important tax-related questions, contact our office today to speak with a member of our professional staff.
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