IRS Tax Problems

Understanding the Employee vs. Independent Contractor Payroll Classification for Business Owners

by
Sonu Shukla
on
9/18/2017
Understanding the Employee vs. Independent Contractor Payroll Classification for Business Owners

Unless you operate your business entirely by yourself, you rely on other people to help you get things done. In some cases you may hire an employee and in others you may pay people who are entirely outside of your business. Though it may seem like a distinction without a difference between the two, when it comes to paying taxes there is a bright line between an employee and an independent contractor that you need to understand. Knowing and acknowledging the characteristics of each one is the deciding factor on whether you hold taxes on their behalf, as well as your own tax obligations, expenses, and documentation requirements. Getting this wrong can end up costing you a lot in the long run.

Advantages and Disadvantages to Misclassification

The Internal Revenue Service takes worker misclassification very seriously, and so do state authorities. More and more businesses are misclassifying the people they are paying for work, and it’s not always an accident. There is a tax and financial advantage to identifying a worker as an independent contractor instead of an employee, as the costs are lower and the obligations fewer. Independent contractors do not require health benefits, workers’ compensation insurance overtime, or payroll taxes. There isn’t eve a requirement that they are paid the minimum wage, and are certainly not entitled to receive unpaid leave under the Federal Family and Medical Leave Act (FMLA) or 401K benefits.

As for the workers themselves, there are benefits to being classified as independent contractors for them too. Though they would lose the potential for the employee benefits cited above, as well as vacation pay and sick time, as independent contractors they also would gain the ability to set up their own retirement plans and deduct certain business expenses.

Determining Factors

The truth is that the advantages and preferences of both the business and the worker matter less than the key characteristics that the IRS uses to identify independent contractors versus employees. They make their determination based on the answers to the following questions:

  1. Who controls the way that the work is done? If the business directs all aspects of how the work is done, including providing instructions and training, then the worker is an employee.
  2. Who controls the finances and business operations having to do with the job that the worker is doing? If the business can control these aspects of the job, then the worker is an employee.
  3. What is the relationship between the worker and the owner of the business? If the worker perceives the business owner as their boss, then the relationship is that of an employee. If they view them as a client, then they are an independent contractor.

Why It Matters to Your Business

The question of how to classify a worker may seem like nothing but a matter of semantics, but that’s not the way that the IRS sees it. When your business gets it wrong and identifies a worker who is an employee as an independent contractor, you are likely to end up having to pay penalties for not having paid the appropriate taxes and for not filing the appropriate tax documentation.

If you’re not sure how to classify a specific worker, the IRS is willing to help. To get an answer, either a business owner or a worker can fill out Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding).  This form can only be used to assist with existing relationships: the agency will not provide answers to “what if” questions.

Sonu Shukla, CPA writes for TaxBuzz, a tax news and advice website. Reach his office at [email protected].

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Sonu Shukla

Sonu Shukla

Sonu Shukla is a CPA, accountant, and tax preparer based in Orlando, FL. Sonu Shukla can assist you with your tax preparation and planning needs. Sonu is more than just another accountant in Orlando, Florida; he is a small business owner himself. It is a position in life that grants him the perspective and insight to emphasize with his clients, bringing them the best service possible. A Certified Public Accountant and a Certified Financial Planner, Sonu possesses the skills, education and experience to demonstrate unerring business acumen and passionately planned financial strategies. Being proactive is key for Sonu, tailoring highly efficient tax plans for his small business clients, all in a one on one environment where he and the client can bounce ideas around until every detail is worked out.

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