It is important to properly classify your workers because employee classification determines whether an employer must withhold income taxes and pay Social Security, Medicare taxes, and unemployment tax on wages paid to employees. For workers classified as independent contractors, businesses usually do not have to withhold or pay such taxes on payments.
According to the IRS, there are three categories that may help to classify a worker. They are Behavioral Control, Financial Control, and Relationship of the Parties.
Behavior Control states that a worker is an employee if the business has the right to direct and control the work performed by the worker. Categories of this sort include:
- Type of instructions given, such as time to work and location of where to work, and what tools one must use or where to purchase supplies/services (these types of instructions may indicate a worker is an employee).
- Degree of instruction, with more detailed instructions indicating that the worker is likely an employee. On the other hand, less detailed instructions mean less control, and that means the worker is more likely to be an independent contractor.
- Training how to do the job or training about procedures and methods is evidence that the worker is an employee because independent contractors tend to use their own methods.
Financial Control discusses whether the business has a right to direct or control the financial and business aspects of the worker’s job. Categories to consider include:
- Notable investment in the equipment the worker uses.
- Unreimbursed expenses. Usually, independent contractors are more likely to experience unreimbursed expenses compared to employees.
- Method of payment. Employees are generally guaranteed a regular wage amount for a set period of time. On the other hand, independent contractors are usually paid a flat fee.
Relationship of the Parties mentions that the type of relationship depends upon how the worker and business perceive their interaction with each other. Categories to consider include:
- Written contracts that openly describe the intended relationship. However, note that a contract stating the worker is an employee or an independent contractor is not enough to determine the worker’s status.
- Benefits of working for the company. Businesses that provide employee-type benefits (insurance, a pension plan, vacation pay) usually mean that the business has employees. These benefits are usually not offered to independent contractors.
- Expecting that the relationship will continue indefinitely, rather than for a specific project/period, is seen as the intent to create an employer-employee relationship.
What Is the Penalty for Misclassifying an Employee as An Independent Contractor?
Misclassifying employees as independent contractors with no reasonable basis for doing so makes employers liable for heavy penalties from the IRS and may prove to be a heavy burden on one’s finances.
The IRS offers a program that provides taxpayers the opportunity to properly reclassify their workers as employees for future periods with partial relief from federal employment taxes for eligible taxpayers that agree to treat their workers as employees in the future. This is known as the Voluntary Classification Settlement Program (VCSP).
Examples of Independent Contractors
Simple examples of independent contractors include but are not limited to some auto mechanics; many, if not most real estate agents; some accountants who have their own office; some attorneys who have their own firm; etc.