The IRS and You ... what it takes to be an Independent Contractor

The IRS and You
What it takes to be an Independent Contractor


From IRS publication: Tax Guide for Small Business

For more details, see Who Are Employees? in Publication 937

NOTE: The IRS can be very fussy, so please refer to their Independent Contractor page for a complete definition.

Before you can know how to treat payments you make for services rendered to you, you must first know the business relationship that exists between you and the person performing those services. The person performing the services may be:

  • An independent contractor;
  • A common-law employee;
  • A statutory employee; or
  • A statutory non employee.

Independent contractors.

People such as lawyers, contractors, subcontractors, public stenographers, auctioneers, etc., who follow an independent trade, business, or profession in which they offer their services to the general public are generally not employees. However, whether such people are employees or independent contractors depends on the facts in each case. The general rule is that an individual is an independent contractor if you, the employer, have the right to control or direct only the result of the work and not the means and methods of accomplishing that result. You do not have to withhold or pay taxes on payments you make to independent contractors.

Common-law employee

Under common law rules, every individual who performs services subject to the will and control of an employer, as to both what must be done and how it must be done, is an employee. It does not matter that the employer allows the employee discretion and freedom of action, so long as the employer has the legal right to control both the method and the result of the services. Two usual characteristics of an employer-employee relationship are that the employer has the right to discharge the employee and the employer supplies tools and a place to work.

If you have an employer-employee relationship, it makes no difference how it is described. It does not matter if the employee is called an employee, partner, coadventurer, agent, or independent contractor. It does not matter how the payments are measured, how they are made, or whet they are called. Nor does it matter whether the individual is employed full time or part time. For employment tax purposes, no distinction is made between classes of employees. Superintendents, managers, and other ~ personnel are all employees. An officer of a corporation is generally an employee, but a director is not An officer who performs no services or performs only minor services, and neither receives nor is entitled to receive any pay, is not considered an employee

You may have to withhold and pay taxes on wages you pay to common-law employees. Statutory employees. If an individual who works for you is not an employee under the common law rules, you do not have to withhold federal income tax from that individual's pay. However, for social security and Medicare taxes, the term employee includes any individual who works for you for pay in one of the following four categories:

1) A driver who distributes meat products, vegetable products, fruit products, bakery products, or beverages (other than milk), or picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.

2) A full-time life insurance salesperson.

3) An individual who works at home on materials or goods which you supply and which must be returned to you or to a person you name, if you also furnish specifications for the work to be done.

4) A full-time traveling or city salesperson, who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyers' business operations.

Social Security and Medicare taxes:

Individuals within any of these categories an employees subject to social security an Medicare taxes if:

The service contract states or implies that almost all of the services are to be performed personally by them: The individual has little or no investment in the equipment and property used to per-form the services (other than an investment in transportation facilities); and The services are performed on a continuing basis.

Federal unemployment tax.

For federal unemployment tax, the term employee means the same as it does for social security and Medicare taxes, except that it does no include insurance salespersons or individuals who work at home. Reporting payments to statutory employee & Furnish a Form W-2 to a statutory employee, and check Statutory employee in box 15. Show your payments to the employee as other compensation in box 1 Also show social security tax withheld in box 4 social security wages in box 3, Medicare wages in box 5, and Medicare tax withheld in box 6. The statutory employee can deduct his or her trade or business expenses from the payments shown on Form W-2. He or she reports earnings as a statutory employee on line 1 of Schedule C. (A statutory employee's business expenses are not subject to the reduction by 2% of his or her adjusted gross income that applies to common-law employees.)

Statutory non employee

Two categories of statutory non employees have been established: direct sellers and licensed real estate agents. They are treated as self-employed if:

1) Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked; and

2) Their services are performed under a written contract providing that they will not be treated as employees for federal tax purposes.

For more information on direct sellers, see Publication 911.

Employer.employee relationship. In doubtful cases, the facts will determine whether or not there is an actual employer-employee relationship. For an

in-depth discussion and examples of the common law employer-employee relationship, see Who Are Employees? in Publication 937. If you want the IRS to determine whether a worker is an employee, file Form S~ with the District Director for the area in which your business is located.

Penalty for treating an employee as an in-dependent contractor

If you classify an employee as an independent contractor and you had no reasonable basis for doing so, you can be held liable to pay employment taxes for that worker (the relief provisions, discussed below, will not apply). Further, if you do not withhold income, social security, and Medicare taxes from his or her wages, you may be held personally liable for a penalty equal to such taxes if you are the person responsible for the collection and payment of withholding taxes. See Penalties under Deposits, later.

Relief provisions. If you have a reasonable basis for not treating a worker as an employee, you may be relieved from having to pay employment taxes for that worker. To get this relief, you must file all required federal tax returns, including information returns, on a basis consistent with your treatment of the worker. You (Or your predecessor) must not have treated any worker holding a substantially similar position as an employee for any periods beginning after 1977. For more information, see -Revenue Procedure 8~1 8 in Internal Revenue Cumulative Bulletin 1 98~1, page 518.

Additional Info presented for study purposes only.

Hiring independent contractors rather than employees to work in your business has some major advantages. Not only do you gain considerable payroll tax savings by retaining independent contractors, but you have far fewer administrative headaches.

Unfortunately, just because you hire someone and you agree that he or she will be an independent contractor, it does not necessarily make it so for tax and legal purposes. So before you hire anyone to work for you as an independent contractor, you need to take a hard look at whether the IRS or a court of law would consider that person to be your employee rather than an independent contractor. While the IRS uses a 20-factor test to evaluate whether a person is or is not an employee, a few major warning flags will indicate to you whether the person is your employee, as opposed to being a contractor. These include:

  • The person works mostly or only for your firm - that is, the person is not like a lawyer, for example, who has a number of clients besides you that he or she works for. The worker is subject to your control, and you have the right to direct how the work is done, not just to demand a particular result.
  • The person works in your office or establishment and does not have his or her own place of business, business cards, or business name. The kind of work the person does for you is normally done by employees, such as secretarial work.
  • The person is not a licensed professional of any type.

Unless you are quite clear that the work relationship will not be considered that of employer/employee, be very careful about hiring someone as a so-called independent contractor. The consequences of being wrong can be severe. Here are just a few of the things that can happen if your independent contractor is determined to be an employee:

You are liable for not only the employer payroll taxes you failed to pay, but also for a portion of the employee taxes you failed to withhold, for example, income taxes and FICA tax.

If you treat someone as an independent contractor, report payments of $600 or more a year to that person on IRS Form 1099-MISC. If you do, and the IRS later determines the person was really an employee, the back taxes you are liable for are limited to the employer payroll taxes, 20% of the employee's FICA tax you failed to withhold, and income tax withholding equal to only 1.5% of the wages you paid the person. If you do not file Form 1099-MISC and the person is reclassified as an employee, you are liable for 40% of the employee's FICA tax and income tax withholding equal to 3% of the wages - twice as much as if you would have filed Form 1099-MISC. Furthermore, there is a $100 penalty for failure to file Form 1099-MISC, and you will owe interest on the taxes due. It is no longer a bargain to "borrow" from the IRS.

You may also be assessed other penalties if you did not have a reasonable basis for treating the person as a non employee and may be liable for up to 100% of the employee's FICA and income tax that you failed to withhold. If the person is hurt on the job and you have not provided worker's compensation insurance coverage, you will be liable for extensive legal damages. If your business has a qualified retirement plan and you have not contributed to the plan on behalf of the person because he or she was not thought to be an employee at the time, the retirement plan could be disqualified for tax purposes for failing to cover the employee in question. Thus, do not get stampeded into the independent contractor game by your friends and business associates who tell you how simple it is to avoid all those payroll taxes.

The above discussion of independent contractors summarizes federal rules only. Many states take an even more restrictive view than the IRS on the employee versus independent contractor issue. You can take a number of steps to strengthen your case for someone who works for you to be treated as an independent contractor. Obviously, not all of the items listed below will necessarily be feasible in every case. Furthermore, a number of these steps, if implemented, may require some significant changes in the way you do business. But if you can follow most of the suggestions below with regard to a given worker, you will improve your odds against having the IRS reclassify that worker as an employee.

Have a written agreement, signed by both parties, that makes it clear the company doesn't have the right to control the methods or procedures for the worker to accomplish the work contracted for. Include language in the agreement that states it is the worker's obligation to pay income and self-employment taxes on amounts earned, and that he or she will receive a Form 1099 reflecting amounts earned if the amount earned is $600 or more.

Try to avoid setting working hours by hour or week. It would be all right to specify starting and completion dates for the work. Make it clear that if additional workers are needed to help, the contractor will hire and pay them. The arrangement should make it clear that the contractor is not limited to working exclusively for you, but is free to take on other work from other customers.

Compensation should be based on what work is performed rather than the time spent to do it. This may require careful estimates so that the worker is fairly paid, not overpaid, for the work done. Avoid providing office space to the contractor on a regular basis. Let the workers be responsible for their own training if that is possible. Each worker should be advised, in writing, to provide for their own liability, workers' compensation, health, and disability insurance coverage. Costs such as meals, transportation, and clothing should be built into the contract price of the job, rather than being billed directly to your account.

It should be clear in your agreement with the worker that he or she can't be fired and can't quit. The worker's job is to fulfill a given work contract. Don't give the worker other work to fill in during down time. This may mean, of course, that you will have to pay the worker somewhat more for the work done than you otherwise would if you wish to keep him or her happy. Don't pay bonuses to a person you treat as an independent contractor.

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