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Since rules have existed for what makes someone an employee or an independent contractor, there has been confusion over which label applies. We've got some answers for you based on new WHD guidance.
UPDATE: As we were preparing this post, the Department of Labor finalized a new ruling on the classification of employees and independent contractors under the Fair Labor Standards Act (FLSA). You can read more about this new rule at www.dol.gov.
In order for a business owner to know how to treat payments made to workers for services, he or she must first know the business relationship that exists between the business and the person performing the services. A worker’s status determines what taxes are paid and who is responsible for reporting and paying those taxes.
A worker performing services for a business is generally an employee or an independent contractor. If a worker is classified incorrectly, the IRS may assess penalties on the employer for nonpayment of certain taxes.
Penalties and Interest
When the IRS determines that a worker is actually an employee rather than an independent contractor, the employer is subject to penalties for failure to withhold and remit income, FICA (Social Security and Medicare) and FUTA (federal unemployment tax) taxes, interest on the underpaid amounts, and penalties for failure to file information returns. The state will also seek to collect workers’ compensation and unemployment compensation premiums for unreported wages.
Independent Contractor
An independent contractor is self-employed and is generally responsible for paying his or her own taxes through estimated tax payments. A business issues Form 1099-NEC, Nonemployee Compensation, to any one independent contractor, subcontractor, freelancer, etc., to whom the business made $600 or more in payments over the course of the tax year. The business is not generally responsible for withholding income tax or FICA for an independent contractor.
Note: Only direct payments (cash or check) are included for the $600 limit. Payments made through a third-party processor, such as PayPal or Venmo, are not included.
Employee
A worker treated as an employee will be issued Form W-2, Wage and Tax Statement, for wages paid. The business hiring the worker is responsible for withholding income tax
and FICA. The employer is also liable for FUTA and various state employment taxes. Also, the employee may be eligible for certain fringe benefits offered by the employer, such as health care.
Factors to Determine Worker Status
The general rules for classifying workers as independent contractors or common-law employees center on who has the right to control the details of how services are to be performed. The six factors considered are the following:
Opportunity for profit or loss depending on managerial skill.
Investments by the worker and the employer.
Permanence of the work relationship.
Nature and degree of control.
Whether the work performed is integral to the employer’s business.
Skill and initiative.
Unlike the old three-factor test, all six factors are weighted equally. These new "economic realities" are much more nuanced than previous historical guidance.
The Wage & Hour Division of the Department of Labor has a provided Fact Sheet 13: Employee or Independent Contractor Classification Under the Fair Labor Standards Act (FLSA) to help businesses determine if a worker can be an independent contractor or must be an employee.
Example Scenario #1
Harold owns a restaurant and hires Jim, a gardener, to mow the lawn and weed the landscaping once a week after receiving a glowing recommendation from one of Jim's other clients. The contract states that Jim will arrive at the restaurant on Monday mornings, mow the lawn, pull weeds, and tend to the landscaping. In exchange, Harold agrees to pay Jim $100 for this service each week. Jim supplies his own lawnmower, weed eater, and hedge clippers. Jim decides what time he arrives and how long the job will take him. Harold does not supervise Jim in his tasks or dictate to him how they are to be done.
Do you think Jim can be an independent contractor or should he be an employee?
Jim is an independent contractor. Let's look at the factors to see why:
Opportunity for profit or loss depending on managerial skill. -- Jim can charge more for his services as he is responsible for overseeing all work.
Investments by the worker and the employer. -- Harold is not investing anything in Jim or Jim's company. Jim is providing his own equipment and supplies that are not usually kept by a restaurant.
Permanence of the work relationship. -- Jim has other clients to whom he offers the same or similar services. Again, Harold is not providing Jim with any tools or supplies to complete the agreed upon work. Harold is also not paying any taxes for Jim.
Nature and degree of control. -- Jim providing this own equipment and supplies, setting his schedule, and deciding how long to work at Harold's site shows that Harold has no control over the agreed upon work.
Whether the work performed is integral to the employer’s business. -- While Harold may think his restaurant's flower beds and grassy areas being tidy and well maintained is integral, they are not. Because those services have nothing to do with cooking, serving, ordering, or any other food-based task, they are typically deemed nonintegral.
Skill and initiative. -- Jim is required to have a skill set that is not needed to prepare food or maintain indoor cleanliness. Jim is, again, setting his own arrival time to complete the tasks how he sees fit.
Example Scenario #2
Jeffrey owns Jeffrey’s Gardening Service and employs three gardeners to perform services for his business. Jeffrey pays his gardeners a fixed wage and withholds taxes, FICA, and various benefits and remits those withholdings to the appropriate government agencies. In addition, Jeffrey provides his employees with the tools and equipment they need to perform their work, instructs his employees which jobs to go to, and supervises them while they are doing their work.
Do you think Jeffrey's workers can be an independent contractors or should they be employees?
Jeffrey’s workers are employees. Let's look at the factors to see why:
Opportunity for profit or loss depending on managerial skill. -- Jeffrey's workers are managed by Jeffery. He tells them where to go and when.
Investments by the worker and the employer. -- Jeffrey is paying FICA (Social Security and Medicare) taxes for these workers*. He (assumedly) is also providing on-the-job training/coaching to the workers to make sure jobs are done his way.
Permanence of the work relationship. -- Jeffrey tells the workers where to be, when, and for how long as he is managing their work on site. Jeffrey
Nature and degree of control. -- Jeffrey manages his workers while they are doing the work and (assumingly) answers questions they have when issues arise.
Whether the work performed is integral to the employer’s business. -- The workers are performing tasks that Jeffrey can do, yes; however, without this workers, Jeffrey would not be able to operate efficiently in his business as he would be doing ever job himself taking up all of his time.
Skill and initiative. -- The workers are performing the tasks as instructed and overseen by Jeffrey.
*It is important to note that the payment of employer-based taxes - unemployment (federal and state), Social Security, Medicare, etc. - typically creates an automatic employee relationship with a worker.
One last thought we will leave you with: The Wage & Hour Division (WHD) and the Internal Revenue Service technically have different definitions of what makes a worker an employee or an independent contractor. We recommend to use the WHD guidance as it is more in-depth and comprehensive.
Legal Disclaimer: This post contains general information for taxpayers and should not be relied upon as the only source of authority. Taxpayers should seek professional tax advice for more information. This information was current at time of posting; we are not responsible for updating this or any blog post/article for subsequent changes in the law or its interpretation.
Certain content on this page is copyright © 2024 Tax Materials, Inc. while some is from the United States Department of Labor Wage and Hour Division website. All Rights Reserved for applicable content. Used with permission from respective sources.
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