IRS Determination of Employee vs. Independent Contractor
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Introduction
Worker classification is a very important issue to those effected by it. The Federal Insurance Contributions Act (FICA) tax is comprised of Social Security (12.4%) and Medicare (2.9%) for a grand total of 15.3%. Regular employees pay half of the tax (7.65%) while employers are responsible for the other half. While the tax is deductible for employers, employees are unable to deduct their portion of FICA taxes.
Contractors (self-employed individuals), on the other hand, are responsible for the entire FICA tax through self-employment taxes that are filed with their individual tax return. Contractors, however, are able to deduct half of the self-employment tax (which would otherwise be the employer's portion) against their taxable income for the year.
This difference in taxation has caused some employers to misclassify their employees as contractors to avoid their 7.65% responsibility. Thankfully, the IRS has released guidance detailing it's interpretation of the classifications and has provided a method for receiving a determination in the event of a disagreement between the worker and business.
Classification
There are 3 main elements that the IRS examines to determine the nature of the relationship between a worker and a business:
Behavioral Control - Behavioral control deals with who is in control of the work performed. Degree and type of instruction, the extent of the evaluation systems, and the level of training provided are key elements. If a business can tell a worker when, where and how a job will be performed, an employee/employer relationship generally exists. Another key element is whether the worker performs the task on the employer's premises.
Financial Control - Financial control concerns the extent to which a business controls the financial aspects of a worker's job. Who owns the equipment, whether the worker has multiple clients, who pays for expenses, and the opportunity for a profit or loss are key elements for determining financial control. If a worker is paid a set amount (hourly, salary, etc.) on a regular basis (weekly, bi-weekly, etc.), they are generally considered an employee. If they are paid by job, they might be properly classified as a contractor.
Relationship - The relationship between the worker and business is the final factor in determining the nature of the relationship. Written contracts, benefits provided to the worker, and the permanency of the relationship are key elements of this factor. If the services of the worker are seen as a key aspect of the business of the company, an employee/employer relationship is more likely to exist.
For any given relationship, it is important to consider all the facts and circumstances in reaching a classification for a worker.
Status Determination
In the event that a taxpayer believes that they are being misclassified as an independent contractor, they may file for SS-8 (link provided below) to receive a determination from the IRS. The form includes a series of questions to be answered by the taxpayer which describes their working conditions and helps the IRS form the basis for a conclusion. To the extent that the IRS finds that the worker was misclassified, they will be entitled to tax relief for the half of the FICA tax incorrectly assessed and will pursue the employer.
If a taxpayer believes that they have been improperly classified, they are entitled to file form 8919 and only pay the employee's half of the FICA tax. Note, however, that this filing position may only be taken if the taxpayer has not already received a determination from the IRS or are awaiting response.
References
https://www.irs.gov/newsroom/understanding-employee-vs-contractor-designation
https://www.irs.gov/pub/irs-pdf/fss8.pdf
https://www.irs.gov/pub/irs-pdf/f8919.pdf
Disclosure
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
@OriginalWorks
I'm assuming that any work contracted using a site like Fiverr or Upwork would be exempt from this, right? Or would the people atill be cpnsidered contractors? Both sites take a cut of the payment for facilitating the transaction, but all communication is done directly between the buyer and the freelancer.
Based on my rudimentary understanding of Fiverr and Upwork (I haven't used them myself), the sites serve as a platform for businesses to hire workers to perform specific projects remotely. Likely, the worker would qualify as a contractor assuming that they control the work product, the environment that they work in, and are paid by project (not on an ongoing basis).
As a result, the worker would be subject to self-employment tax. The business would be required to issue a 1099 to the worker at the end of the year which the worker would report on Schedule C subject to self-employment taxes on Schedule SE.
This determination, however, would be dependent upon the facts and circumstances surrounding the employment relationship. They would not be exempt from FICA taxes (the worker would either play the employee's half or the entire amount).
it's not only the IRS or employee/contractor that you have to be concerned about, but also workers comp and the state. a business that I used to work for was audited by both EDD and workers comp and they each came to two different conclusions after the audit. bottom line, make sure that you have a clear signed contract on file for each contractor that you do business with. even then, be prepared to owe money.
That's a very good point. I was focused on the income tax impact, but the potential legal exposure exists beyond what I was specifically addressing.
People like you deserve rewards, success always
Thanks!