Correctly classifying workers as employees or independent contractors is essential for business owners to meet tax obligations and avoid costly penalties. The IRS provides clear guidelines, including a 20-factor test, to help determine the correct classification. Here’s what you need to know to navigate this complex area and protect your business.
Why Classification Matters
Employers are required to withhold income, Social Security, and Medicare taxes for employees and pay unemployment tax. However, employers are generally not responsible for tax withholding for independent contractors. Misclassification can lead to significant penalties and back taxes.
Worker Classifications
The IRS recognizes several worker categories:
- Independent Contractors: Self-employed professionals like lawyers, accountants, and contractors. The key factor is control—independent contractors are free to determine how to achieve the results of their work.
- Common-Law Employees: Workers are considered employees if the employer controls how and what work is performed, even if the worker has autonomy in some areas.
- Statutory Employees: Certain workers, such as life insurance sales agents or delivery drivers, may be classified as employees for tax purposes under specific conditions.
- Statutory Nonemployees: Direct sellers, licensed real estate agents, and certain companion sitters are treated as self-employed if their income is based on output rather than hours worked and a written agreement exists.
- Government Workers: Public officials are generally classified as government employees.
Common-Law Rules
The IRS uses three categories to evaluate the level of control and independence:
- Behavioral: Does the employer control how the worker completes tasks?
- Financial: Are business aspects like payment and expense reimbursement controlled by the employer?
- Type of Relationship: Are there contracts, employee benefits, or expectations of ongoing work?
These factors must be weighed collectively, with no single factor being decisive.
The 20-Factor Test
The IRS no longer uses the 20-Factor Test to determine whether a worker is classified as an employee or an independent contractor. Instead, the IRS has streamlined the classification process into the three key areas mentioned above: behavioral control, financial control, and type of relationship.
However, the questions from the 20-Factor Test remain a valuable resource for businesses to verify they are correctly classifying workers. By evaluating these factors, companies can better understand the key elements influencing worker classification and avoid potential compliance issues. Here are the questions:
- Can the worker profit or suffer a loss from doing the work aside from their pay for the project?
- Does the worker have an investment in the equipment or facilities used to do the work?
- Does the person work for multiple companies at a time?
- Does the worker offer services to the public?
- Does the employer have the right to give the worker instructions about when, where, and how to work?
- Does the employer train the worker to do the job in a particular way?
- Are the worker’s services so important to the business that they have become a necessary part of the business?
- Must the worker provide the services personally instead of delegating them to someone else?
- Does the company hire, supervise, and pay the worker’s assistants?
- Is there an ongoing relationship between the worker and the owner?
- Are the worker’s hours set by the employer?
- Must the worker spend all his time on the job?
- Must the individual work on-site, or can the employer control the route or location where the work must be performed?
- Does the employer have the right to determine the order in which services are performed?
- Must the worker provide reports accounting for his or her actions?
- Is the worker paid by the hour, week, or month?
- Does the company pay the worker’s business or travel costs?
- Does the company provide the worker with equipment, tools, or materials?
- Can the worker be fired?
- Can the worker quit at any time without incurring liability?
A “yes” to the first four questions suggests independent contractor status, while a “yes” to the remaining questions indicates employee status.
Special Considerations
- Remote Workers: Workers who perform duties off-site may still be classified as employees if the employer controls the work.
- Form SS-8: If the classification is unclear, the business or the worker can file Form SS-8 for an official IRS determination.
Avoiding Misclassification
Misclassifying an employee as an independent contractor without a reasonable basis can result in liability for employment taxes and penalties. However, businesses with consistent and reasonable classification practices may qualify for relief.
Voluntary Classification Settlement Program
The IRS offers the Voluntary Classification Settlement Program (VCSP), which allows businesses to reclassify workers as employees with reduced penalties. Interested businesses must file Form 8952 to apply.
Need Help?
Determining worker classification can be complex, but proper classification is essential for compliance. Contact Stephano Slack’s tax professionals for tailored guidance at 610-687-1600 or email [email protected]. Your compliance is our priority!
Author Martha Eckhardt, EA, is a highly skilled Senior Tax Manager and Office Manager at Stephano Slack’s Haddonfield office. With a sharp focus on individual tax compliance, Martha excels in handling complex multi-state cases and serving high-net-worth clients. Her expertise includes managing trusts, preparing gift tax returns, and overseeing private foundations’ 990-PFs. Additionally, Martha brings specialized knowledge in Expat tax returns and associated Equalizations. For personalized tax solutions, reach her at 856-528-5386 or [email protected].
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