You may be one of the many
individuals who is surprised to find out the tax consequences of
independent contract work. Whether you are receiving money
as an independent contractor or paying someone to do work for you
as an independent contractor you need to understand the full tax
consequences of your working arrangement.
As you probably know, if a worker is an
employee, the business (payor) must withhold federal income and payroll taxes,
must pay the
employer's share of FICA taxes on the wages plus FUTA tax, and may have to provide the
worker with fringe benefits it makes available to other employees. There may be
state tax obligations as well.
These obligations don't apply for a worker who is
an independent contractor. The business sends the independent contractor a Form
1099-MISC for the year showing what he or she was paid (if it amounts to $600 or
more), and that's it.
Who is an “employee?” There is no uniform
definition of the term. The question of whether a worker is an
independent contractor or employee for federal income and employment tax
purposes is a complex one. It is intensely factual, and the stakes can be very
high.
Under the common-law rules (so-called because
they originate from court cases rather than from the tax code), an individual
generally is an employee if the enterprise he works for has the right to control
and direct him regarding the job he is to do and how he is to do it. Otherwise,
he is an independent contractor.
Some employers that have misclassified workers
as independent contractors are relieved from employment tax liabilities under
Section 530 of the '78 Revenue Act (not the Internal Revenue Code). In brief,
Section 530 protection applies only if the employer: 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. For example,
a “reasonable basis” exists if a significant segment of the employer's
industry has traditionally treated similar workers as independent contractors.
Section 530 doesn't apply to certain types of technical services workers.
Individuals who are “statutory employees,”
(that is, specifically identified by the tax code as being employees) are
treated as employees for social security tax purposes even if they aren't
subject to an employer's direction and control (that is, even if the individuals
wouldn't be treated as employees under the common-law rules). These individuals
are agent drivers and commission drivers, life insurance salespeople, home
workers, and full-time traveling or city salespeople who meet a number of tests.
Statutory employees may or may not be employees for non-FICA purposes. Corporate
officers are statutory employees for all purposes.
Individuals who are statutory independent
contractors (that is, specifically identified by the tax code as being
non-employees) aren't employees for purposes of wage withholding, FICA or FUTA,
and the income tax rules in general. These individuals are qualified real estate
agents and certain direct sellers.
Some categories of individuals are subject to
special rules because of their occupations or identities. For example, corporate
directors aren't employees of a corporation in their capacity as directors, and
partners of an enterprise organized as a partnership are treated as
self-employed persons.
Under certain circumstances, you can ask IRS
(on Form SS-8) to rule on whether a worker is an independent contractor or
employee.
In determining whether the
person providing service is an employee or an independent
contractor, all information that provides evidence of the degree
of control and independence must be considered.
Common Law Rules
Facts that provide evidence of
the degree of control and independence fall into three categories:
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Behavioral: Does the
company control or have the right to control what the worker
does and how the worker does his or her job?
Behavioral Control
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Behavioral
control refers to facts that show
whether there is a right to direct or control
how the worker does the work. A worker is an
employee when the business has the right to
direct and control the worker. The business
does not have to actually direct or control
the way the work is done – as long as the
employer has the right to direct and control
the work.
The
behavioral control factors fall into the
categories of:
Types
of Instructions Given
An employee
is generally subject to the business’s
instructions about when, where, and how to
work. All of the following are examples of
types of instructions about how to do work.
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When and
where to do the work.
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What
tools or equipment to use.
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What
workers to hire or to assist with the
work.
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Where to
purchase supplies and services.
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What work
must be performed by a specified
individual.
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What
order or sequence to follow when
performing the work.
Degree of Instruction
Degree of
Instruction means that the more detailed the
instructions, the more control the business
exercises over the worker. More detailed
instructions indicate that the worker is an
employee. Less detailed instructions
reflects less control, indicating that the
worker is more likely an independent
contractor.
Note:
The amount of instruction needed varies among
different jobs. Even if no instructions are
given, sufficient behavioral control may exist
if the employer has the right to control how
the work results are achieved. A business may
lack the knowledge to instruct some highly
specialized professionals; in other cases, the
task may require little or no instruction. The
key consideration is whether the business has
retained the right to control the details of a
worker's performance or instead has given up
that right.
Evaluation System
If an
evaluation system measures the details of how
the work is performed, then these factors
would point to an employee.
If the
evaluation system measures just the end
result, then this can point to either an
independent contractor or an employee.
Training
If the
business provides the worker with training on
how to do the job, this indicates that the
business wants the job done in a particular
way. This is strong evidence that the
worker is an employee. Periodic or on-going
training about procedures and methods is even
stronger evidence of an employer-employee
relationship. However, independent contractors
ordinarily use their own methods.
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Financial: Are the business
aspects of the worker’s job controlled by the payer?
(these include things like how worker is paid, whether
expenses are reimbursed, who provides tools/supplies, etc.)
Financial Control
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Financial
control refers to facts that show whether or
not the business has the right to control the
economic aspects of the worker’s job.
The
financial control factors fall into the
categories of:
Significant
investment
An independent
contractor often has a significant investment
in the equipment he or she uses in working for
someone else. However, in many
occupations, such as construction, workers
spend thousands of dollars on the tools and
equipment they use and are still considered to
be employees. There are no precise dollar
limits that must be met in order to have a
significant investment. Furthermore, a
significant investment is not necessary for
independent contractor status as some types of
work simply do not require large expenditures.
Unreimbursed expenses
Independent
contractors are more likely to have
unreimbursed expenses than are employees.
Fixed ongoing costs that are incurred
regardless of whether work is currently being
performed are especially important. However,
employees may also incur unreimbursed expenses
in connection with the services that they
perform for their business.
Opportunity for profit
or loss
The opportunity
to make a profit or loss is another important
factor. If a worker has a significant
investment in the tools and equipment used and
if the worker has unreimbursed expenses, the
worker has a greater opportunity to lose money
(i.e., their expenses will exceed their income
from the work). Having the possibility
of incurring a loss indicates that the worker
is an independent contractor.
Services available to
the market
An
independent contractor is generally free to
seek out business opportunities. Independent
contractors often advertise, maintain a
visible business location, and are available
to work in the relevant market.
Method of payment
An employee
is generally guaranteed a regular wage amount
for an hourly, weekly, or other period of
time. This usually indicates that a worker is
an employee, even when the wage or salary is
supplemented by a commission. An independent
contractor is usually paid by a flat fee for
the job. However, it is common in some
professions, such as law, to pay independent
contractors hourly.
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Type of Relationship: Are
there written contracts or employee type benefits (i.e.
pension plan, insurance, vacation pay, etc.)? Will the
relationship continue and is the work performed a key aspect
of the business?
Type of Relationship
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Type of
relationship refers to facts that show how the
worker and business perceive their
relationship to each other.
The factors,
for the type of relationship between
two parties, generally fall into the
categories of:
Written
Contracts
Although a
contract may state that the worker is an
employee or an independent contractor, this is
not sufficient to determine the worker’s
status. The IRS is not required to
follow a contract stating that the worker is
an independent contractor, responsible for
paying his or her own self employment
tax. How the parties work together
determines whether the worker is an employee
or an independent contractor.
Employee
Benefits
Employee
benefits include things like insurance,
pension plans, paid vacation, sick days, and
disability insurance. Businesses
generally do not grant these benefits to
independent contractors. However, the
lack of these types of benefits does not
necessarily mean the worker is an independent
contractor.
Permanency of
the Relationship
If you hire
a worker with the expectation that the
relationship will continue indefinitely,
rather than for a specific project or period,
this is generally considered evidence that the
intent was to create an employer-employee
relationship.
Services
Provided as Key Activity of the Business
If a worker
provides services that are a key aspect of the
business, it is more likely that the business
will have the right to direct and control his
or her activities. For example, if a law
firm hires an attorney, it is likely that it
will present the attorney’s work as its own
and would have the right to control or direct
that work. This would indicate an
employer-employee relationship.
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Businesses must weigh all these
factors when determining whether a worker is an employee or
independent contractor. Some factors may indicate that the worker
is an employee, while other factors indicate that the worker is an
independent contractor. There is no “magic” or set number of
factors that “makes” the worker an employee or an independent
contractor, and no one factor stands alone in making this
determination. Also, factors which are relevant in one situation
may not be relevant in another.
The keys are to look at the
entire relationship, consider the degree or extent of the right to
direct and control, and finally, to document each of the factors
used in coming up with the determination.
If you'd like to discuss these complex rules
with me and see how they apply to your business in order to make sure that none
of your workers are misclassified, please call my office to arrange for an
appointment.
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What Do You Do if You Forget to Send Out 1099's by
the February 1 Deadline?
If you are a small business owner or self-employed person who hires independent
contractors you may be required by the IRS to send out a Form 1099-MISC to those people.
Read the following to help you determine your obligation to issue 1099's.
The basic rule works like this: Form 1099-MISC is used to report total annual payments made to independent contractors who made at least $600 during the previous calendar year. This 1099 must be given or mailed to the contractor by January 31 of the following year.
Note: Since January 31, 2010 was a Sunday, the deadline was extended to the next business day (Monday, Feb. 1, 2010).
The key here is whether or not the person who worked for you is self-employed. Obviously, this excludes employees. If you have employees, you give them a Form W-2 by January 31 (or Feb. 1) to report their compensation (wages, salaries, bonuses, and withholdings). And this also means you don't have to send out a 1099-MISC to corporations who provided services to your business.
The purpose of the 1099-MISC is similar to that of the W-2, but the goal here is to report income made by non-employees, not employees. And this is why the annual total income of self-employed contractors is reported in Box 7 of the 1099, "Nonemployee compensation."
The 1099s provide a way to track payments and the IRS is expecting you to
help them keep track of the income of the self-employed.
There are many self-employed workers who
receive no 1099's, and report no income, even though the law says they are supposed to report the income whether or not they receive a 1099.
Keep in mind that if you take a deduction for payments to independent contractors but don't issue the corresponding 1099's, and you get audited, you
will have to pay the tax, punitive penalties and interest or possibly
worse. Don't take chances... go ahead and issue the 1099's.
What if the February 1 deadline has already passed? Go ahead and issue the 1099's anyway. Give the contractor a call right away and tell him you are sending him a 1099 as soon as possible.
For details on how to comply with the 1099 reporting rules, download the Form 1099 instructions from the IRS website or consult with your tax professional. You'll want to send Form 1099-MISC Copy B to the self-employed person right away and Form 1099-MISC Copy A, along with Form 1096, to the IRS by March 1, 2010.
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