Contractor or employee? Know the differences

Hiring independent contractors is a common solution for business owners to reduce payroll costs — especially during times of staff shortages and inflationary pressures. If you’re among them, be careful that these workers are properly classified for federal tax purposes. If the IRS reclassifies them as employees, it can be an expensive mistake.

Determining whether a worker is an independent contractor or an employee for federal income and employment tax purposes isn’t always easy. If a worker is an employee, your company must withhold federal income and payroll taxes and pay the employer’s share of FICA taxes on the wages, plus FUTA tax. There also may be state tax obligations, not to mention health benefits and other financial perks.

On the other hand, if a worker is an independent contractor, these obligations don’t apply. In that case, the business simply sends the contractor a Form 1099-NEC for the year showing the amount paid (if it’s $600 or more).

Employee or contractor? 

Who qualifies as an “employee?” Unfortunately, there’s no uniform definition of the term.

The IRS and courts have generally ruled that individuals are employees if the organization they work for has the right to control and direct them in the jobs they’re performing. Otherwise, the individuals are generally independent contractors. But other factors are also taken into account, including who provides equipment and who pays expenses.

Some employers that have misclassified workers as independent contractors may get relief from employment tax liabilities under Section 530. This protection generally applies only if an employer meets certain requirements. For example, the employer must file all federal returns consistent with its treatment of a worker as a contractor and it must treat all similarly situated workers as contractors.

Section 530 doesn’t apply to certain categories of workers.

You can ask the IRS, but …

You can use Form SS-8 to ask the IRS to determine whether a worker is an independent contractor or employee. You should also be aware that the IRS has a history of classifying workers as employees rather than independent contractors. Filing Form SS-8 can also raise classification concerns with the IRS and unintentionally trigger an employment tax audit.

It may be better to properly set up a relationship with workers to treat them as independent contractors so that your business complies with the tax rules.

Workers who want an official determination of their status can also file Form SS-8. Dissatisfied independent contractors may do so because they feel entitled to employee benefits and want to eliminate their self-employment tax liabilities.

If a worker files Form SS-8, the IRS will notify the business with a letter. It identifies the worker and includes a blank Form SS-8. The business is asked to complete and return the form to the IRS, which will render a classification decision.

Reach out to our tax services team us if you’d like to discuss how to classify workers at your business. We can help make sure your workers are properly classified.

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