The relationship between the employer and the worker is not always straightforward, but despite the possible discrepancies, it is extremely important to properly classify your workers. The tax implications vary depending on the type of worker, and the penalties for misclassifying a worker can be huge.
This HR Insights is not intended to be exhaustive nor should any discussion or opinions be construed as professional advice.
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How to Properly Classify Your Workers-Types of Workers
Before determining how to treat payments your company makes for services, you must categorize the business relationship that exists between your company and the person performing the services. Is the worker an employee or a type of independent contractor? Workers may be categorized as one of the following four types, as defined by the Internal Revenue Service (IRS):
Employee: Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.
Statutory Employee: 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), 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 of your name, if you also furnish specification 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, 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.
Social Security and Medicare taxes: Withhold Social Security and Medicare taxes from the wages of statutory employees if all three of the following conditions apply:
- The service contract states or implies that substantially all the services are to be performed personally by them.
- They do not have a substantial investment in the equipment and property used to perform the services (other than an investment in transportation facilities).
- The services are performed on a continuing basis for the same payer.
Statutory Non-employee: There are generally two categories of statutory non-employees: direct sellers and licensed real estate agents. They 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.
Independent Contractor: People such as doctors, 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.
How to Properly Classify Your Workers-Additional Resources
Because not every worker can be easily classified in one category, it is important to take the entire working relationship into account. Consider the extent of the right to direct and control the services of the worker. And after you’ve classified the worker, document each of the factors used to determine how you came to your classification decision. Remember, the financial impact of misclassifying a worker can be substantial.
Consider contacting a tax adviser if you are uncertain about a worker’s status. Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding (www.irs.gov/uac/About-Form-SS8), can be filed with the IRS. The IRS will review the facts and circumstances and officially determine the worker’s status.
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