Is your worker an independent contractor or an employee?

This query, amid others, was asked of me by a state tax auditor in the mid 1990s. I was running a small business and we had taken on my partner’s high school neighbor to fill in when we needed some cheap labor. On a cold day in October, a state revenue agent arrived to do an audit. Our records were in his words, “a mess,” and he concentrated his due diligence on our check book. He soon came across this young man’s name and the amounts that we had paid him. “Is this an employee,” he asked? “Independent contractor,” I replied. He then began to rattle off a staccato of memorized definitions of independent contractors and finished his dissertation with, “show me his business card.” I paid the $400.

The question of whether a worker is an independent contractor or employee for federal income and employment tax purposes is not any clearer today than it was 20 years ago. Not only is the definition blurry and gray but a complex one as well. It is intensely factual, and the stakes can be very high. If a worker is deemed an employee, the company must withhold federal income, payroll taxes, and pay the employer’s share of FICA and FUTA taxes. Medical, retirement and other benefits must be available to all who are considered employees. As I had found out, there may be state tax obligations as well, associated with part-time and full-time employees. If your work force meets the requirements to be independent contractors, then these same obligations don’t apply. You will then only have to send the independent contractor a Form 1099-MISC, for any monies paid that exceed $600.

The question that still needs to be answered is, “Who is an employee?”  The problem is there is no uniform definition of the term by the IRS.

Independent Contractor Defined – IRS Website

  • People such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public are generally independent contractors. However, whether these people are independent contractors or employees depends on the facts in each case. The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. The earnings of a person who is working as an independent contractor are subject to Self-Employment Tax.
  • You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed.
  • If an employer-employee relationship exists (regardless of what the relationship is called), you are not an independent contractor and your earnings are generally not subject to Self-Employment Tax.
  • However, your earnings as an employee may be subject to FICA (Social Security tax and Medicare) and income tax withholding.

If you have misclassified workers as independent contractors and they were employees you can be relieved from employment tax liabilities under Section 530 of the 1978 Revenue Act (not the Internal Revenue Code). Section 530 protection applies only if the employer has filed all federal returns consistent with its treatment of a worker as an independent contractor; treated all similarly situated workers as independent contractors; and had a “reasonable basis” for not treating the worker as an employee.

Statutory Employees – IRS Website

If workers are independent contractors under the common law rules, such workers may nevertheless be treated as employees by statute (statutory employees) for certain employment tax purposes if they fall within any one of the following four categories and meet the three conditions described under Social Security and Medicare taxes, below.

  • 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.

Individuals who are “statutory employees,”  are treated as employees for social security tax purposes even if they aren’t subject to an employer’s direction and control.

Statutory Nonemployees – IRS Website

There are three categories of statutory nonemployees: direct sellers, licensed real estate agents, and certain companion sitters. Direct sellers and licensed real estate agents are treated as self-employed for all federal tax purposes, including income 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 will not be treated as employees for federal tax purposes.

Direct sellers – Direct sellers include persons falling within any of the following three groups.

  1. 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.
  2. 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.
  3. 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).

Individuals who are statutory independent contractors aren’t employees for purposes of wage withholding, FICA, or FUTA and the income tax rules in general.

It is advisable to have a tax professional look at all of your employees or independent contractors and their status and how they will effect you. We, at garvey & garvey llc CPAs, can easily assist business owners with establishing a method that is appropriate for them so there are no unwelcome surprises when there year end tax returns are filed.