How is it determined whether a taxpayer can be an independent contractor (1099) or an employee (W2)?
In general, a company that misclassifies an employee (“EE”) as an independent contractor (“IC”) may be held liable for that employee’s Social Security taxes because, in an employer-employee relationship, the employer is responsible for one-half of the tax owed, and the employer is responsible for deducting the employee’s portion of the tax from wages.
The IRS has ruled that if an employer wrongly classifies an individual as an IC, the IRS can offset the refund of any self-employment taxes (15.3%) paid by that individual but only with the EE portion of the employment taxes that would have been owed had the employer been properly classified. That can be messy…as I am sure you can guess.
Therefore, if an employer hires an IC who is later found to be an EE, the EE can claim a refund for the self-employment taxes paid while the EE was erroneously believed to be an IC. The IRS, when processing the refund, can reduce the amount refundable to the EE by the employment taxes the EE would have paid with proper classification. The employer, however, remains liable for the remaining balance that was refunded to the employee.
Oh, there’s more, we’re not done yet.
An EE that has been “misclassified” as an IC may also be entitled to claim benefits under the benefit plans that the employer has established for traditional employees. Now, wouldn’t that be fun to go back and figure out?
Lastly, EEs of a temporary or employment agency can claim benefits of the company that has leased them from the agency! Isn’t that fun? By the way, don’t trust the employment agencies to be experts on the law in this area. If they tell you something about IC and EE classification, I would put as much faith behind it as I would in a house built of straw.
- Address this issue before you start hiring people. Talk to both your CPA and Employment Law attorney. Set a written guideline policy and process – stick to it.
- File form SS-8 with the IRS for each person you want to classify as an IC.
Now, let’s back up a second. How do we go about classifying a person as either an IC or an EE? Well, that’s very black and white….not. Quite the opposite, in fact.
In general, the law favors the classification of any person as an EE. The burden is quite squarely on the employer to show that someone should instead be an IC.
A lot of the classification concepts can revolve around control. If an employer has the right to control (and be careful, because the government applies this “right to control” very liberally) and direct the person’s work, they are almost always considered an employee. On the other hand, if the individual performing the work is only under the control of the employer to the extent of the end result that must be delivered, that individual could be classified as an IC.
Note this important distinction: The employer does not have to actually direct and control the person’s work, they merely have to have the right to do so. This is very often overlooked by companies.
Again, we’re not done yet with this issue of control. The IRS has developed a 20 factor test that is often applied in determining whether an individual is performing services as an EE or an IC. For the purposes of this article, I will keep this as brief as I can, but you should do your own research. Please do not rely on this list as a complete description of what you need to know. I am making general statements.
- If the person is receiving instructions from the employer, they are an EE.
- If the person has to be trained by the company or an EE of the company, they are an EE.
- If a material business success or failure rides on the person’s efforts, they are deemed an EE.
- If the services are rendered personally, it is presumed that the company that hired the person is interested in the methods used to accomplish the work, therefore making them an EE.
- If the person controls other EEs of the company, they are an EE.
- If there is a continuing relationship, an EE relationship can be assumed.
- If work hours are established by the company, the person is an EE.
- If the person works substantially a full-time work week, an EE classification can be assumed.
- If the person is working on the company’s premises, the assumption of control exists.
- If the person must complete the work in a certain order, this implies control.
- If the person submits oral or written reports, control is assumed.
- Payment by the Hour, Week, or Month – implies the person is an EE. Payment by the job or on a straight commission implies the person is an IC.
- Payment of the person’s business or travel expenses – implies the person is an EE.
- If the person is furnished tools or materials to complete their work, control is assumed.
- If the person is handling a “significant investment” made by the company, control is assumed.
- If the person performing the work can experience a profit or loss as a result of their work, they are generally assumed to be an IC.
- If the person is working for more than one company at a time, this suggests that they are an IC.
- If the person makes their services available to the general public, that suggests that they are an IC.
- If the company can fire or discharge the person at will, it is assumed that they are an EE. If they cannot be fired so long as they are discharging their duties, an IC relationship can be established.
- Right to Terminate – If the individual has the right to terminate the relationship without incurring liability, this indicates an EE relationship is present.
In closing, all the facts and circumstances must be considered in weighing these factors to determine whether the relationship is an EE or an IC relationship. No one factor will be determinative in making the correct classification.
Document, document, document. Have a process that very specifically has the goal of making honest determinations and establish guidelines.
And, as always, you will need to consult with a CPA to get specific advice to your own situation.
How can an employer take steps in order to ensure that their independent contractors are properly classified and not be retroactively be deemed employees?