Tuesday, March 4, 2008
Tax Issues - Employee vs Independent Contractor
Employee vs Independent Contractor is a critical decision that can have far reaching impact on both the worker and employer. Many employers attempt to establish the status of an individual as an independent contractor rather than an employee. It is a complex issue and can be pivotal in determining the financial well being of many employers. As an independent contractor the employer is obligated to pay a set amount for the agreed upon job or for hours worked. Once they are paid that s the end of the employer s obligation. As an employee there are a whole series of tax obligations. First there is FICA taxes (Social Security taxes), unemployment taxes, workers compensation insurance and pay for time not worked such as vacations and holidays. Independent contractor s income is reported to the IRS on form 1099-MISC. No tax deductions are made and the contractor receives the entire gross amount. The independent contractor then must report the income on their tax return and pay whatever taxes are due, including, if appropriate, SE FICA taxes. Individuals who are classified as employees are paid a net amount with the appropriate taxes withheld and the amounts, including taxes withheld, annually reported to the IRS on form W-2. The employer must periodically during the year remit the withheld taxes to the IRS. Control, including financial and behavioral and the relationship between the parties are critical in determining the individual s status. Get it wrong and there can be huge tax liabilities and penalties for the employer. Failure to deduct and pay FICA taxes, for example, beyond the financial penalties, could result in jail time for company executives. The IRS guidelines on this issue can be confusing. Control both financial and behavioral along with the relationship between the parties are critical issues. Many a business have assumed that a part-time or project worker is automatically an independent contractor and learned later at their financial peril when the IRS reclassifies the workers as employees and demands back taxes, interest and penalties. So how is it determined if a worker is an employee or an independent contractor? From a tax perspective there is really no specific definition. The courts have ruled that an individual is generally an employee if who he works for has the right to control and direct the work he is doing and how he is to do it. In the absence of this control he is an independent contractor. Determining what is control varies from situation to situation. The analysis, however, has some additional complexity. If the employer determines that the worker is an independent contractor he may still run into problems. The Internal Revenue Code contains definition for individuals that are considered "statutory employees." These individuals are treated as employees for social security tax purposes even if they aren t subject to the employer s direction and control and a court would find these workers to be independent contractors. For example, agent drivers, commission drivers, life insurance sales people, home workers and city salespeople who meet a number of tests are considered employees for tax purposes. The employer would indicate on the workers Form W-2 whether the worker is classified as a statutory employee. Statutory employees report their wages, income and allowable expenses on Schedule C (or schedule C-EZ) Form 1040. Statutory employees are not liable for self-employment tax because the employer treats them as employees for social security tax purposes and deducts and pays the applicable FICA tax. Corporate officers are statutory employees for all purposes. Qualified real estate agents and certain direct sellers are specifically identified by the tax code a being non-employees and are statutory independent contractors and are not employees for purposes of tax withholding. Have you confused? If an employer intends to have people working and is unsure of their status the first step is to get an opinion letter from a tax professional. Further, the IRS has a 20 point questionnaire on Form SS-8 that is used to make a determination as to the workers status. It s infinitely better to get a proper determination before the worker is hired than to find out later that the independent contractor was in fact an employee. The financial and personal costs to the employer are too great to guess or leave it to chance. Andy Andersohn is a small business owner and long time tax preparer. Learn more valuable tax planning resources for business owners and individuals. Get your FREE 11 page Tax Saving Guide . Find up to date tax articles. At his tax planning site , discover more tax help and good ideas.