By James Hamon, Senior Associate
Do you know the difference between an employee and an independent contractor? For small business owners, this is a very common question they often find themselves asking. Often it is unclear whether the person completing the job is considered a company employee or an independent contractor. The answer will have important tax implications. If a worker is to be considered an employee, and receive W-2 compensation, the employer will owe taxes to include FICA, SUTA, and FUTA. An independent contractor will receive a 1099-MISC and will be responsible for BOTH employer and employee portions of the taxes mentioned above.
There are three main elements the IRS lists when making this determination; behavioral control, financial control, and the nature of the relationship.
Behavior control determines how much influence the employer has at work. If the employer is teaching and training the individual, instructing them on how and when to do the work, what tools or equipment to use, it is likely they would be considered an employee as opposed to an independent contractor.
Financial control largely centers on unreimbursed business expenses, investments in supplies and materials used to perform the work, and the extent to which the worker can profit or incur a loss. Unreimbursed business expenses are considered to be ordinary and necessary expenses made by someone, “in the business of being an employee”, that are not paid for by their employer. One must be an employee to have such expenses and able to deduct them on their tax return. If an individual is buying tools or equipment, that are necessary to do their job, they are likely to be considered a contractor investing in their business. Possibly the easiest and most important distinction between an employee and a contractor is the ability to incur a loss or turn a profit. An employee will be paid a W-2 by the employer and earn a fixed salary or hourly wage. A contractor will be earning an agreed upon amount from the company, but will also have expenses such as supplies and materials; hence the ability to profit or lose money from the agreement.
The relationship between the worker and the employer is more difficult to quantify. To help make this determination, one would look at any written contracts that define what relationship the two parties intended to create. An employee would be given benefits such as personal days, insurance, a retirement plan, etc., but a contractor would not. Furthermore, if the worker performs services that are integral to the day-to-day operations or regular business of the company, they would likely be considered as an employee as well. If the worker performs similar work for other clients, decides when and how to do the work and provides their own tools, they might be classified as an independent contractor.
Making correct determination between employee and independent contractor and therefore who is responsible for paying the taxes owed to the IRS for the money exchanged is important. If a worker is incorrectly considered to be a contractor and their status should have been a W-2 employee, what effect will this have? The employer taxes owed will be considered delinquent and a liability to the company, as they were not remitted by the business on time. IRS penalties and interest may apply.
Making the Determination
If in doubt and unable to decide, you may file form SS-8 with the IRS. They will make the determination of whether an individual should be classified as an employee or an independent contractor. If you have any additional questions or concerns, please contact your CST consultant.