Is the person you are hiring your employee or an independent contractor? In many cases the answer is obvious, but sometimes it isn’t. Worker classification continues to be a headache for businesses of all sizes — and an area of interest to the IRS.

Why Does It Matter?

The distinction is important for employment-tax reasons. With an employee, the business and the employee share the responsibility for Social Security and Medicare (FICA) taxes on the employee’s earnings. The business also must pay unemployment taxes for the worker. With an independent contractor, the contractor is fully liable for his or her own self-employment taxes. FICA taxes do not apply, and unemployment taxes are not required.

Benefits are another consideration. A company’s health and retirement plans must cover an employee once the employee meets plan eligibility requirements. An independent contractor typically does not receive benefits.

How To Decide

To answer the worker classification question for federal tax purposes, a company should analyze its entire relationship with the worker, focusing on the degree of direction and control the company exercises. The more control, the more likely it is that a worker is an employee. Three elements come into play:

Behavioral control over what work is done and how it is done (sequence of work tasks, detailed instructions regarding how to perform the job, etc.)

Financial control over the business aspects of the job (who provides tools/supplies, how the worker is paid, whether expenses are reimbursed, etc.)

Type of relationship (whether it is ongoing, written contracts, provision of benefits, etc.)

Businesses that would like the IRS to determine a worker’s status for purposes of federal employment taxes and income-tax withholding can file Form SS-8. The IRS advises that it could take as long as six months to get a determination.

Statute Says

Federal law specifically classifies certain workers as employees for FICA purposes, even if they are not subject to an employer’s control. These include certain agent and commission drivers, a life insurance company’s sales agents, home workers, and full-time traveling or city salespeople. Similarly, two categories of workers are considered statutory nonemployees (i.e., self-employed): direct sellers and licensed real estate agents. (Requirements apply.)

A Little Relief

In some situations, the IRS may relieve a business from having to pay employment taxes for a wrongly classified worker. The business must have a reasonable basis for not treating the worker as an employee and must have been consistent in its treatment.

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