Understanding the difference may help your business avoid a costly headache


By Chris Freeburn


You know who your employees are, right? Of course you do. But are you sure the IRS will agree with you?


That, it turns out, might be a problem. Small businesses often give their employees considerable flexibility in terms of hours and working conditions, and many rely on freelancers and independent contractors to perform specific tasks or take on temporary work. Such outside workers aren't considered "employees," right? Be careful: They may be.


Surprisingly, determining whether someone counts as an independent contractor or an employee does not depend on the amount of time that person works for a company, or even how or when that person is paid. The decisive factor is how much control the company exercises over that person's activities for the company. Generally, if you control only the outcome of the work, by accepting or rejecting the finished product, then the person is an independent contractor. However, if you control not only the finished product, but the means and methods by which it is produced, then the person is an employee. So even if a metalworker spends most of his time working in your shop, if he uses his own tools, sets his own hours, and is not under your control and supervision, he continues to function as an independent contractor. If, however, he uses your tools and materials, during hours you set, and is subject to supervision by company managers while he works, then he has become an employee.

Making the determination between independent contractor and employee is an important decision for you as an employer. Employers are required to withhold income taxes from an employee's salary, as well as pay Medicare, unemployment, and social security taxes on each employee. However, employers generally do not have to withhold and pay such taxes on payments to independent contractors. In the event that that you incorrectly classify a worker as an independent contractor, the IRS can hold you liable for that worker's unpaid taxes in addition to penalties and interest. No statute of limitations exists on these taxes. If the IRS decides that your firm has wrongly classified an employee, you will be liable for these back taxes and penalties for every year of that error.


The IRS defines four possible categories of workers: independent contractors, common law employees, statutory employees and statutory non employees. Statutory employees are workers who might otherwise be defined as independent contractors, except that their jobs have been defined as having employee status by law. Such positions include individuals working from home using materials and goods provided by an employer, which must be returned to that employer; delivery drivers (except for milk deliveries); full-time life insurance salespeople who sell life insurance or annuity contracts for one business; and full time traveling or local salespeople who work on one business' behalf. Statutory non employees comprise direct sellers and licensed real estate agents, who are, by law, treated as self employed. Employers must file IRS form 1099 MISC to report payments in excess of $600 made to independent contractors, but generally have no other tax liability, unlike with regular employees.


Ever vigilant for tax errors, the IRS closely examines taxpayers whose income is mostly reported on 1099 MISC forms, with an eye toward catching firms who improperly list employees as independent contractors. If your metalworker receives the majority of his or her income from just one firm, the IRS may choose to investigate whether he or she truly functions as an independent contractor. That can create a considerable hassle for you, especially if the IRS ultimately decides that the metalworker should have been considered an employee.


If you have difficulty determining whether a worker is properly defined as either an employee or independent contractor, or simply don't wish to risk IRS penalties, you can have the IRS decide the matter itself by submitting Form SS-8. The form asks for a complete description of the worker's duties, extent of employer supervision and salary. You can find Form SS-8 and a variety of advisory publications regarding the rules defining employees and independent contractors at www.irs.gov.


Chris Freeburn is an Associate Editor/Writer for Priority magazine

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