The IRS uses about 20 different tests to weigh in on whether the person working for you should be qualified as an independent contractor or qualified as an employee. Generally speaking the IRS likes to qualify people as an employee for a couple of reasons. For starters you the employer are required to withhold money out of their paychecks, and give it to the IRS. This ensures that the government gets their share right off the bat – instead of finding out at the end of the year that the independent contractor doesn’t have the money set aside to pay their taxes. Also, as an employer you have certain obligations to pay for your employees.
Some of these include:
- Matching the employees Social Security contributions
- Matching the employees Medicare contributions
- Paying federal unemployment tax on your employees
- Paying state unemployment tax on your employees
- Paying workman’s comp on your employees (where applicable)
Because of these requirements, most business owners prefer to have independent contractors instead of employees. Likewise, it is not uncommon for the IRS and other state taxing agencies to inquire if a small or large business has had any independent contractors that can be classified as employees. If one of these organizations goes back and audits your books, and reclassifies your independent contractors as employees, you will be responsible for paying all the back taxes plus late payment penalties and interest. This can add up to thousands of dollars very quickly for a misclassification of your workers. It’s therefore, essential that you simply avoid the misclassification from the beginning. As I said before, there are about 20 different tests that the IRS will use.
Let’s take a look at a few of the most common:
1. Do you control the employees time?
Generally, you as an employer will instruct your employees when they can show up for work and when they can leave. Independent contractors however may generally work on their own schedule as long as the work gets done.
2. Who provided the tools?
If the person comes to your office and uses your desks, computers, electricity, pens, pencils, etc., then they may be considered an employee by the IRS. Independent contractors are generally responsible for providing their own tools as well as maintaining their own workspaces.
3. Can the work be subcontracted out?
When you hire an independent contractor, very frequently they may send any of their employees to perform the actual job functions required. Conversely, an employee is deemed to be the only one qualified to perform their specific job function. As an example, let’s say you had a receptionist for your company, and she didn’t feel like coming in to work today. You wouldn’t allow her to send her cousin to do the work instead.
4. Basis of compensation
Employees are usually paid either an hourly wage or salary. Independent contractors however, are generally paid either on a per job basis or occasionally some form of an hourly fee. For example, if you hire a plumbing contractor they may charge you for $600 for the job of cleaning out your drain lines, or they may charge you $90 per hour to do the same job until it’s complete. An employee usually works a regular set schedule of hours a week or month, or if they are considered salaried, then they are usually expected to work 40 hours per week.
5. Who provides the insurance?
Similar to contractors using their own tools, contractors generally provide their own insurance as well. Employees are generally covered by any general liability or other insurances that a business caries.
6. Corporate safe havens
If the individual performs his or her work from an incorporated entity, they are considered a separate entity and covered under the corporate safe haven. Simple example: instead of hiring Joe Smith, you hire Joe Smith Incorporated to perform the work needed. It is automatically assumed that Joe Smith Incorporated is an independent contractor, and not an employee, and therefore hiring an incorporated businesses rather than individuals to do work solidifies their independent contractor relationship with you. Even if you’re working relationship with that person fails some of the other tests used to determine the status, this one test by itself will still cause that person to be considered an independent contractor.
As I said before, there are several test used, but these are the ones that the IRS will most often utilize. If after reading this, you still have further doubt as to whether someone is an employee or an independent contractor, then it is best to speak with a qualified tax professional as to the specifics of your situation.