As an accountant, I often come across many employers who are uncertain of how they should classify their workers, as well as workers who are uncertain of how their income should be treated. With that said, questions like “Should I have been an employee or independent contractor?” or “How should I be paying my workers?” Are two very common questions that are frequently asked. Nevertheless, being classified under the correct employment status is imperative for both the employer and worker.
There are three general categories of independence that are used to determine the employment status of an individual. These are:
Behavioral: The process of how the work is done is a major concern of the employer (i.e. how the work is performed). In the sense that the employer provides directions, guidance, or training to the worker in order to get the work done rather than merely just being concerned about the result of the work. In other words, does the employer have control over how the work is done or are they simply just concern about the outcome.
Financial: Assesses how the worker is paid, whether they are reimbursed for expenses, as well as who provides the tools/supplies to get the job done.
Type of relationship: Ask the question of whether the worker is obtaining employment benefits (i.e. pension plan, sick pay, insurance, etc.), and will the relationship continue, or will it cease after a certain period.
The employment status of an employee and an independent contractor is mutually exclusive and must be assessed carefully to avoid potential penalties and fees. With using the categories provided by the IRS, it is important to note that one size does not fit all. Therefore, each situation must be assessed differently to configure the accurate outcome.
Below are some examples of factors that may distinguish an employee from an independent contractor.
Tax Treatment
Employees:
The wages an employee earns is subject to taxation before it is received. Taxes are withheld from each payment received throughout the year on behalf of the employee and is then paid by the employers to each government agency. Doing so helps the employee to stay clear of having the responsibility of withholding taxes on their own. Taxes are withheld based on the information provided by the employee on Form W4. At the end of the year the income earned by the employee is reported on Form W2.
Independent Contractor:
Being an independent contractor in the eyes of the IRS automatically classifies the worker as being self-employed. Being classified in this manner requires substantial amount of responsibility, and little to none on the employer side. The income received by an independent contractor is not subject to withholding by the employer but by the contractor. Therefore, the independent contractor is responsible for ensuring that all taxes are paid to each agency. At year end, the employer is obligated to issue Form 1099MISC, which reports all income earned by the independent contractor.
How to avoid the pitfalls of being an independent contractor:
As an IC the general rule of thumb with income earned is 70 to 30. This means that of the entire income earned 70% is taken home and 30% is paid into taxes (includes federal, state, and local).
Make estimated tax payments. The recommended interval for making estimated payments is monthly or quarterly. When an IC makes estimated tax payments they are paying into FICA and helping to avoid the huge lumpsum that they may be presented with as self-employment taxes. These payments can be made via online, over the phone, or by mail. If a taxpayer anticipates owing more than $1,000 it is required by the IRS that this action is taken.
Keep a spreadsheet or use an online software (i.e. QuickBooks Online) to track all expenses associated with the work being done. This helps to keep track of the inflow and outflow of money as an independent contractor. However, all expenses recognized must be substantiated by proof.
If you use a space in your home to work out of, set it up and get comfortable, because that is a tax deduction. Just ensure that the space is used exclusively and regularly for the work being done. This is called a Home Office Deduction.
It is vital that a worker is aware of their employment status, because it could result in the worker owing a lot of taxes, while having a tremendous amount of responsibility. Nevertheless, when in doubt about a worker’s employment status the IRS encourages employers to treat them as an employee until it can be determined. Employers can ask the IRS for help with classification using Form SS-8, however, until they receive a response from the IRS the employer should continue classifying the worker as an employee.