As a business owner, you will hire certain individuals as employees. With employees you are required to withhold federal income tax and FICA Tax (Social Security & Medicare Taxes) from the employees’ wages. The amount of federal income tax withhold is determined by what the employee claims as dependents on their W-4 form. The FICA withholding is 7.65% of the employees’ wages. The total payroll cost of FICA is 15.3%, 7.65% from the employee and 7.65% from the employer.
The business is not required to withhold federal income tax on FICA taxes from the amounts you pay the independent contractor. In Addition, the business is not required to pay the FICA match. The independent contractor will be responsible to pay all federal income taxes and FICA taxes.
There are times and situations where a business hires independent contractors to address certain business related needs. When the business pays an independent contractor, they receive nonemployee compensation. Nonemployee compensation includes payments of fees, commissions, prizes, and awards for services.
When hiring someone you must determine whether a worker is an employee or an independent contractor. Determining whether a worker is an employee or an independent contractor can be difficult. Misclassifying a worker as an independent contractor can result in paying back wages, taxes, and possibly penalties and interest.
The IRS uses a “Right-To-Control Test”, commonly referred to as the “IRS 20 Factor Test” to determine if an independent contractor relationship exists. Under IRS rules and common-law doctrine, independent contractors control the manner and means by which services, products, or results are delivered. The more control a business exercises over how, when, where, and by whom work is preformed, the more likely the worker is an employee and not an independent contractor. No individual factor is decisive in determining status. Each case is determined on its own merit. The more factors that indicate independent contractor status the better, if you have classified the worker as an independent contractor.
The 20 Factors used to evaluate right to control and the validity of independent contractor classifications include:
- Level of Instruction: If the company directs when, where, and how work is done, this control indicates a possible employment relationship.
- Amount of Training: Requesting workers to undergo company-provided training suggests an employment relationship since the company is directing the methods by which work is accomplished.
- Degree of Business Integration: Workers whose services are integrated into business operations or significantly affect business success are likely to be considered employees.
- Extent of Personal Services: Companies that insist on a particular person performing the work assert a degree of control that suggests an employment relationship. In contrast, independent contractors typically are free to assign work to anyone.
- Control of Assistants: If a company hires, supervises, and pays a worker’s assistants, this control indicates a possible employment relationship. If the worker retains control over hiring, supervising, and paying helpers, this arrangement suggests an independent contractor relationship.
- Continuity of Relationship: A continuous relationship between a company and a worker indicates a possible employment relationship. However, an independent Contractor arrangement can involve an ongoing relationship for multiple, sequential projects.
- Flexibility of Schedule: People whose hours or days of work are dictated by a company are apt to qualify as its employees.
- Demands for Full Time Work: Full time work gives a company control over most of a person’s time, which supports a finding of an employment relationship.
- Need for on-site services: Requiring someone to work on company premises – particularly if the work can be performed elsewhere – indicates a possible employment relationship.
- Sequence of work: If a company requires work to be performed in a specific order or sequence, this control suggests an employment relationship.
- Requirements for Reports: if a worker regularly must provide written or oral reports on the status of a project, this arrangement indicates a possible employee relationship.
- Method of Payment: hourly, weekly, or monthly pay schedules are characteristics of employment relationships, unless the payments simply are a convenient way of distributing a lump-sum fee. Payment on commission or project completion is more characteristic of independent contractor relationships.
- Payment of Business or Travel Expenses: Independent contractors typically bear the cost of travel or business expenses, and most contractors set their fees high enough to cover these costs. Direct reimbursement of travel and other business costs by a company suggests an employment relationship.
- Provision of Tools and Material: Workers who preform most of their work using company-provided equipment, tools, and materials are more likely to be considered employees. Work largely done using independently obtained supplies or tools support an independent contractor finding.
- Investment in Facilities: Independent contractors typically invest in and maintain their own work facilities. In contrast, most employees rely on their employer to provide work facilities.
- Realization of Profit or Loss: Workers who receive predetermined earnings and have little chance to realize significant profit or loss through their work generally are employees.
- Work for Multiple Companies: People who simultaneously provide services for several unrelated companies are likely to qualify as independent contractors.
- Availability to Public: if a worker regularly makes services available to the general public, this supports an independent contractor determination.
- Control over Discharge: A company’s unilateral right to discharge a worker suggests an employment relationship. In contrast, a company’s ability to terminate independent contractor relationships generally depends on contract terms.
- Right of Termination: Most employees unilaterally can terminate their work for a company without liability. Independent contractors cannot terminate services without liability, except as allowed under their contracts.
According to the manual the IRS uses to train its worker classification auditors, the three most important factors are:
- Instructions to Workers: your worker is probably an employee if you require him/her to follow instructions on when, where, and how work is to be done. This is a very important factor. However, if you tell your electrician you want blue switch plate covers instead of white, you are not exercising control to a degree that would make the person an employee.
- Job Training: if your company provides or arranges for training of any kind for the worker, this is a sign you expect work to be performed in a certain way; therefore, the worker is your employee. Training can be as informal as requiring the worker to attend meetings or work along with someone who is more experienced.
- Worker’s Ability to Make a Profit or Suffer a Loss: An employee may be rewarded, disciplined, demoted, or fired depending on job performance, but only an independent contractor can realize a profit or incur a financial loss from his/her work. In other words, an employee will always get paid; an independent contractor, however, has a financial stake in his enterprise.
To build a solid case for independent contractor the business and the worker sign a written agreement stating the worker is an independent contractor who will be paid by the job or project, provides his/her own tools and lay out other terms related to the 20 factors above that point to the validity of the independent contractor relationship.
The employee, independent contractor decision can be complicated and fraught with pitfalls if not understood and documented properly. It is worth the business owners time and effort to structure the independent contractor relationship in a manner to avoid expensive mistakes.