As an employer, your first responsibility after determining a worker's legal status to work in the United States, is to properly classify the worker as either an employee or independent contractor.
Tax and Legal Ramifications of Worker Classification
If a worker is classified as an employee, you will be required to withhold certain federal taxes from the employee's gross pay, file employment tax returns, and pay employment taxes to the U.S. Treasury.
If a worker is classified as an independent contractor, you are generally not required to withhold taxes or file employment tax returns. You simply issue Form 1099 to the contractor to report your payments to the contractor.
However, there are situations when you may be required to withhold federal income taxes. Such taxes are called, backup withholding. For example, if an independent contractor does not provide you with a tax identification number (TIN) or gives you an incorrect TIN and you pay that contractor $600 or more for the year, you are required to withhold backup withholding and remit the tax to the U.S. Treasury. The backup withholding rate is 28%.
Each state requires employers to carry workers' compensation insurance. The coverage requirements are set by each state.
Workers' compensation insurance provides benefits to an employee who is injured on the job. Benefits generally include, wage replacement and payment of medical expenses. Workers' Compensation insurance is a no-fault type of insurance, meaning, even if the employee caused his own work-related injury, benefits are still provided.
Misclassifying a worker unintentionally is no excuse.
The IRS will still hold you liable for any taxes that should have been withheld and paid to the U.S. Treasury. In addition to any taxes that may be due, the IRS will also assess penalties and interest on the amount due. This can be very costly, especially if the misclassification has continued for years.
How to Classify Workers
There are two classifications of workers:
- Independent Contractors
Employees are further classified as:
- Common-Law Employees
- Statutory Employees (defined under statutes)
- Statutory Nonemployees (defined under statutes)
Although there are over 60 elements that may be used by the IRS to determine whether a person is a common-law employee, a key element, in word, is control.
If you hire a worker and have the right to control what is done, when it is done, and how it is done (you provide the means and methods for getting the job done), then the worker will generally be classified as an employee.
The IRS states:
Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done.
Here are examples of elements that indicate a worker is an employee:
- You, or someone else in your business, provides supervision.
- You provide the tools, equipment, and supplies for getting the job done.
- You provide a place for the worker to perform his assigned tasks.
- You determine the work schedule.
- A worker does not offer her services to the public (no advertising is done).
- The worker does not provide an invoice to the business for services provided.
- A worker must sign in and out and is required to adhere to guidelines for taking breaks throughout the workday.
- Workers are entitled to paid vacation and sick days.
John is a salesperson employed on a full-time basis by a car dealership. John works 6 days a week. He appraises trade-ins, which are subject to the sales manager's approval. The list of prospective customers belongs to the dealership.
John has to develop leads and report results to the sales manager. Because of his experience, John requires only minimal assistance in closing and financing sales and in other phases of his work. John is paid a commission and is eligible for prizes and bonuses. The dealership pays the cost of John's health insurance and group-term life insurance. John is an employee of the dealership.
Although a worker may be classified as an independent contractor based on common law rules, such worker may also be treated as an employee by statute because of the activity the worker is involved in. This type of worker is known as a statutory employee for certain employment tax purposes.
This situation would happen if the worker falls within any one of the following four categories and meets all three conditions described under Social security and Medicare taxes (following this list):
- A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.
- A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.
- An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done.
- A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer's business operation. The work performed for you must be the salesperson's principal business activity.
Social security and Medicare taxes and statutory employees:
You must withhold social security and Medicare taxes from the wages of statutory employees if all three of the following conditions apply:
- The service contract states or implies that substantially all the services are to be performed personally by the worker(s)
- They don't have a substantial investment in the equipment and property used to perform the services (other than an investment in facilities for transportation, such as a car or truck).
- The services are performed on a continuing basis for the same payer.
Federal unemployment (FUTA) tax and statutory employees:
For FUTA tax (the unemployment tax paid under the Federal Unemployment Tax Act), the term employee means the same as it does for social security and Medicare taxes, except that it does not include statutory employees defined in categories 2 and 3, earlier.
Any individual who is a statutory employee described under category 1 or 4, earlier, is also an employee for FUTA tax purposes and subject to FUTA tax.
Income tax and statutory employees:
Do not withhold federal income tax from the wages of statutory employees.
W-2 reporting for payments made to statutory employees:
Furnish Form W-2 to a statutory employee and report the following items:
- Box 1: Show your payments to the employee as other compensation..
- Box 3: Social security wages
- Box 4: Social security tax withheld
- Box 5: Medicare wages
- Box 6: Medicare tax withheld
- Box 13, Check Statutory employee
Schedule C and statutory employees:
A statutory employee receives a W-2 form from the employer and reports the earnings shown on the W-2 on line 1 of Schedule C (Form 1040), Profit or Loss From Business, or Schedule C-EZ (Form 1040), Net Profit From Business. A statutory employee may deduct expenses related to the income reported on Form W-2 on Schedule C (Form 1040) or C-EZ (Form 1040).
Deducting Job-Related Expenses:
Common-Law Employees -
A common-law employee deducts job-related expenses on Schedule A, Itemized deductions, where such expenses must exceed 2% of adjusted gross income (AGI) to get a tax benefit.
Statutory Employees -
Since job-related expenses of a statutory employee are reported on Schedule C instead of Schedule A, such expenses escape the 2% of AGI floor.
H-2A agricultural workers:
H-2A workers are not statutory employees. Therefore, on Form W-2, do not check box 13 (Statutory employee).
There are three categories of statutory nonemployees:
- Direct Sellers
- Licensed Real Estate Agents
- Certain Companion Sitters.
Direct sellers and licensed real estate agents are treated as self-employed for all federal tax purposes, including income taxes and employment taxes, if:
- Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked, and
- Their services are performed under a written contract providing that they won't be treated as employees for federal tax purposes.
Direct sellers include persons falling within any of the following three groups:
- Persons engaged in selling (or soliciting the sale of) consumer products in the home or place of business other than in a permanent retail establishment.
- Persons engaged in selling (or soliciting the sale of) consumer products to any buyer on a buy-sell basis, a deposit-commission basis, or any similar basis prescribed by regulations, for resale in the home or at a place of business other than in a permanent retail establishment.
- Persons engaged in the trade or business of delivering or distributing newspapers or shopping news (including any services directly related to such delivery or distribution).
Direct selling includes activities of individuals who attempt to increase direct sales activities of their direct sellers and who earn income based on the productivity of their direct sellers. Such activities include providing motivation and encouragement; imparting skills, knowledge, or experience; and recruiting.
Licensed Real Estate Agents:
This category includes individuals engaged in appraisal activities for real estate sales if they earn income based on sales or other output.
Companion sitters are individuals who furnish personal attendance, companionship, or household care services to children or to individuals who are elderly or disabled.
A person engaged in the trade or business of putting the sitters in touch with individuals who wish to employ them (that is, a companion sitting placement service) won't be treated as the employer of the sitters if that person doesn't receive or pay the salary or wages of the sitters and is compensated by the sitters or the persons who employ them on a fee basis.
Companion sitters who are not employees of a companion sitting placement service are generally treated as self-employed for all federal tax purposes.
It's fairly easy to know when you're hiring an independent contractor. For example, hiring a painter to paint your office, or an electrician to do some rewiring, or using a monthly bookkeeping service, are examples of independent contractors.
In each of these cases, the contractor, not you, has the right to control how and when the work gets done and will invoice you for the service rendered. The contractor controls the means and methods of getting the work done as well as determining how much to charge for the service.
With an independent contractor, an entity/client relationship exists as opposed to an employer/employee relationship.
The contractor is responsible for reporting his income and expenses, paying self-employment taxes and federal income taxes, and filing his own tax returns.
A sole proprietor generally reports income and expenses on Schedule C (or Schedule F for farmers) and files Schedule SE, Self-Employment Tax..
A general partner reports income or loss on Schedule E, Supplemental Income and Loss and must also pay self-employment tax on his share of certain partnership income and guaranteed payments.
A word of caution.
Intentionally misclassifying a worker as an independent contractor to save money on employment taxes, when the worker should be classified as an employee, could prove to be a costly mistake if you're ever audited! The IRS is well aware of this ploy. The penalties can be harsh, especially if this practice has been going on for a long time.
Not Sure How to Classify Someone?
If you're not sure how someone should be classified, you can have the IRS give you a determination of a worker's status by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
Need to File Your Personal or Small Business Taxes?
File your personal and small business taxes (Schedule C)
- Return to the Hiring Workers Table of Contents to find related links