Employee or Independent Contractor?

Apr 03, 2014

The question is an important one. Failure to properly classify your workers may subject your business to large financial penalties. Under the “common law” rules developed by the courts, a worker generally is an employee for federal tax purposes if the employer has the right to control and direct the worker regarding the job he is to do and how he is to do it.

Tax Implications

Employees and independent contractors are treated differently for income-tax withholding and employment-tax purposes. With an employee, the business generally must withhold income taxes from the employee’s pay and remit those taxes to the federal (and state, if applicable) government. The business and the employee share the responsibility for Social Security and Medicare (FICA) taxes on the employee’s earnings. The business also must pay unemployment taxes for the worker. With an independent contractor, income-tax withholding is not required and the contractor is fully liable for his or her own self-employment taxes. FICA taxes and unemployment taxes do not apply.

Stiff Penalties

The IRS penalty for the unintentional failure to withhold federal income tax is 1.5% of the wages paid. Also, if IRS Form 1099-MISC (an “information return”) is not filed, the penalty is doubled to 3% of wages paid. As for Social Security and Medicare taxes, an employer’s unintentional failure to withhold the employee’s share of the tax results in a 20% IRS penalty. That assessment is doubled to 40% for an employer’s failure to also file an information return for the worker.

An intentional misclassification of the worker by the employer results in an income-tax liability equal to the amount that should have been withheld and 100% of the employee’s and employer’sshare of the Social Security and Medicare taxes.

Making the Call

If there is a question about whether a particular worker is an employee or an independent contractor, a company should analyze its entire relationship with the worker. The primary focus should be the degree of direction and control the company exercises over the worker. The IRS has a number of specific factors that come into play, but, in general, the more direction and control, the more likely it is that a worker is an employee.

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