Taxes & Worker Status: Employee vs. Independent Contractor?

If you are a small business owner, whether you hire people as independent contractors or as employees will impact the amount of taxes you withhold from their paychecks, as well as the amount and types of taxes you pay.  Furthermore, it will affect how much additional cost your business must bear, what documents and information must be provided to you, and what tax documents must be given to the individuals you are hiring.

The obvious advantage to treating an individual as an independent contractor is avoiding the added expense of payroll taxes and employee benefits.  Unfortunately, the decision is not an optional one, and employers must be careful when making the decision, lest they set themselves up for a payroll audit and back taxes, penalties and interest.

According to industry sources, the IRS will begin auditing companies in early 2010, focusing their efforts on businesses failing to pay taxes on fringe benefits and misclassifying workers as independent contractors instead of W-2 employees.  

Here are some things every business owner should know about hiring people as independent contractors versus hiring them as employees.

• Three characteristics are used by the IRS to determine the relationship between businesses and workers: Behavioral Control, Financial Control, and the Type of Relationship.

• Behavioral Control covers facts that show whether the business has a right to direct or control how the work is done through instructions, training or other means.

• Financial Control covers facts that show whether the business has a right to direct or control the financial and business aspects of the worker's job.

• The Type of Relationship factor relates to how the workers and the business owner perceive their relationship.

• If you have the right to control or direct not only what is to be done, but also how it is to be done, then your workers are most likely employees.

• If you can direct or control only the result of the work done, and not the means and methods of accomplishing the result, then your workers are probably independent contractors.

• Employers who misclassify workers as independent contractors can end up with substantial tax bills.  Additionally, they can face penalties for failing to pay employment taxes and not filing required tax forms.

• Workers can avoid higher tax bills and lost benefits if they know their proper status.

• Employers can request the IRS to make a determination on whether a specific individual is an independent contractor or an employee by filing a Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) with the IRS. A worker may also file Form SS-8, requesting an IRS determination. IRS does not issue determinations for proposed or hypothetical situations.

If you need more information about the critical determination of a worker’s status as an independent contractor or employee, please give this office a call.