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Determining if Your Worker is an Independent Contractor or Employee

Business owners are required to withhold federal, social security and Medicare taxes from employee paychecks and forward these funds to the Internal Revenue Service (IRS). This is not required for workers who fall under the classification of independent contractors. Because of this, employers are sometimes tempted to classify workers as independent contractors who are actually employees. It is important that you understand the difference between these two employment situations so you do not find yourself in trouble with the IRS.

Employee Classifications According to IRS Law

The IRS separates workers into four different categories. You must select the classification that is most appropriate among the following:

  • Independent Contractor: A person performing work for you is considered to be an independent contractor if you have the right to control and direct the work that he or she performs for you. However, you are not permitted to dictate the work that gets done and how the independent contractor goes about the job. Many professionals, such as doctors and dentists, offer their services to others as an independent contractor. Workers who meet the criteria for this description are considered to be self-employed and must pay self-employment taxes.
  • Common-Law Employee: Under this IRS classification, anyone who performs work for you is considered your employee if you maintain control of the work to be performed and how it is to be accomplished. Most employers provide their employees with a benefits package in addition to their actual salary.
  • Statutory Employee: There are four specific circumstances when workers who are independent contractors under common-law rules may be considered statutory employees for federal tax purposes.
  • Statutory Non-Employee: Certain companion sitters, real estate agents and direct sellers are considered statutory non-employees for federal tax purposes.

Consider Common-Law Rules When Choosing an Employment Designation

The IRS looks at the degree of independence workers have verses the amount of control that you have as the employer to determine how their employment should be classified. The following three factors play an important role in the decision-making process:

  • Behavioral Control: The business owner retains the right to control the work assigned to the employee and how it is performed, whether or not he or she exercises that right. The IRS considers type of instructions given, degree of instructions, training provided and how the worker is evaluated for the purpose of analyzing behavioral control.
  • Financial Control: The IRS considers whether or not the business owner has the ability to control several financial aspects of the worker's job. Financial control factors include method of payment, opportunity for profit or loss, services available to the market, significant investment and unreimbursed expenses.
  • Type of Relationship: The IRS considers how the worker and the business owner perceive their relationship to one another. The four specific factors it evaluates include written contracts, employee benefits, relationship permanency and the degree to which the services provided by the employee are instrumental to the success of the business.

If you are still unclear whether to classify your worker as an employee or an independent contractor, you may complete the Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, which is IRS Form SS-8. The IRS reviews the information and notifies you of its decision within six months.

Potential Penalties for Classifying Employees as Independent Contractors

The IRS may hold you liable for employment taxes if you have classify an employee as an independent contractor when you had no basis to do so. Relief provisions may be available if you file the correct paperwork with the IRS.