Your business needs help. You engage a worker to meet this need. Be sure that you properly classify this worker — as an employee or independent contractor — so you can meet your tax-filing requirements and other legal responsibilities. The IRS is continually reminding small businesses to get this right. Here’s what’s at stake and how you can correctly classify your worker.
Employer tax-filing responsibilities
What are your tax-filing requirements for an employee versus an independent contractor?
For an employee. You have various tax-filing requirements, including:
- Quarterly reporting of withholding from the employee’s wages for income taxes and the employee’s share of FICA as well as the employer’s share of FICA.
- Annual reporting for FUTA (federal unemployment tax).
- State reporting for withholding of state income tax (if applicable) and state unemployment tax.
- Form W-2 to the employee to report wages and certain benefits for the year. A transmittal must be sent to the Social Security Administration (not to the IRS).
For an independent contractor. Your only requirement is to issue an annual Form 1099-MISC to report non-employee compensation if total payments for the year are $600 or more. You furnish a copy to the worker and a transmittal to the IRS.
Whichever classification you use, the annual reporting to the worker — on a W-2 or 1099 — is a chore. But it doesn’t have to be; you can, for example, use efile4biz.com to figure the cost of these W-2s and 1099s and then easily prepare and file them electronically.
Correct worker classification
In addition to filings, there are payroll tax costs for having an employee. Figure that federal, state, and local employer taxes with respect to an employee’s wages are about 10% of those wages. This means it costs an employer $4,000 for an employee with wages of $40,000. Then add on the cost of employee benefits, such as health insurance and retirement plan contributions, workers’ compensation, and compliance with various labor laws and the costs mount. In contrast, for an independent contractor, there’s zero cost; taxes, benefits, and insurance are born solely by the contractor (although payments to the contractor may be higher than wages to an employee).
So there’s a cost incentive to treat a worker as an independent contractor. But you can’t just apply the label and make it stick. It has to be accurate. The IRS uses various factors to determine worker classification:
- Behavioral. Do you have the right to control when, where, and how the work gets done?
- Financial. Who controls the business aspects of the work? For example, when and how is the worker paid, who bears the cost of expenses, who provides the tools and supplies?
- Relationship of the parties. How do the business and the worker view the relationship? Is there a written agreement? Is the relationship finite (i.e., only for a specific project rather than indefinite)? Are benefits, such as vacation pay, insurance and pension plans provided to the worker?
The IRS says there is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination.” Worker classification may become easier if pending legislation is enacted. The New Economy Works to Guarantee Independence and Growth (NEW GIG Act) would create a safe harbor under which workers can be treated as independent contractors, and the customer (and the online platform used to find the worker, if applicable) would not be treated as an employer.
The IRS has a main stake in worker classification; it wants to ensure that employment taxes are being paid when owed. But other federal and state agencies can jump into the issue of worker classification to see that employees are protected. Examples of this include:
- Department of Labor seeking to enforce minimum wage and overtime rules
- OSHA seeking workplace safety for employees
- NLRB overseeing unionization for employees
- State unemployment agencies when a former worker seeks this benefit
- State workers’ compensation when a former worker is injured in the course of the job
It’s been reported that independent contractors now make up 34% of the U.S. workforce, and that it’s expected to be 43% by 2020. As the size of the gig economy grows, the issue of worker classification will be of big importance to small businesses. Owners should think long and hard about their business model and which type of workers is best suited for their purposes.
This post was created in collaboration with efile4Biz, a leading IRS-authorized e-file provider committed to helping employers process and file 1099s, W-2s and ACA forms easily and conveniently. All opinions expressed in this post are my own and not those of efile4biz.