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.
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.
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
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
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
holding a substantially similar position as an employee for any
periods beginning after 1977. For more information, see
8~1 8 in Internal Revenue
Cumulative Bulletin 1 98~1, page 518.
Additional Info presented for study
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
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.
- 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
- 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
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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