A business may consider hiring independent contractors instead of bringing on full-time employees for a variety of reasons. The need may be short-term, require a highly specialized skillset, or simply cost less due to decreased payroll, health benefits, and vacation. But limitations exist with hiring independent contractors and it is good business practice to understand a few basics.
We discussed how independent contractors may be considered employees under workers compensation law in a previous post. Here we will consider the topic from the perspective of the IRS, apart from workers compensation law. Remember, the IRS and state workers compensation laws classify employees differently.
FICA, FUTA, SUTA, oh my!
A business is responsible for withholding and paying employment-related taxes for their employees. These can include FICA (Social Security and Medicare), FUTA (federal unemployment), SUTA (state unemployment), and others. However, independent contractors are responsible for maintaining their own tax records and paying their own income and self-employment taxes. Self-employment tax for subcontractors is steep and currently costs 15.3% of wages and net earnings. Adding other taxes and deductions, it is easy to see how subcontractor rates may even be more costly than those of employees.
Independent Contractor versus Employee
Employees are hired to perform work under the direction of the employer. Independent contractors are given a job or project and provided minimum employer supervision. A common example of an independent contractor would be the painters currently outside my office door. We hired them to paint a portion of the interior of our building. However, the painters show up on their own schedule, use their own skill, own tools, and require very little oversight.
Employees require an onboarding process to understand their team, company, job duties, and goals. The relationship is expected to be long-term. Independent contractors do not go through an onboarding process. They are provided the information needed to finish their task and aren’t expected to continue after the job is complete.
The general rule is that a worker is an independent contractor if the business has the right to control or direct the result of the work, and not how it will be performed. The IRS will largely consider 1) control, and 2) relationship when determining if a worker is an independent contractor or employee.
The following is an excerpt from the IRS Tax Tips:
- Control. The relationship between a worker and a business is important. If the business controls what work is accomplished and directs how it is done, it exerts behavioral control. If the business directs or controls financial and certain relevant aspects of a worker’s job, it exercises financial control. This includes:
- The extent of the worker’s investment in the facilities or tools used in performing services
- The extent to which the worker makes his or her services available to the relevant market
- How the business pays the worker, and
- The extent to which the worker can realize a profit or incur a loss
- Relationship. How the employer and worker perceive their relationship is also important for determining worker status. Key topics to think about include:
- Written contracts describing the relationship the parties intended to create
- Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation or sick pay
- The permanency of the relationship, and
- The extent to which services performed by the worker are a key aspect of the regular business of the company
- The extent to which the worker has unreimbursed business expenses
Penalties for misclassification and can vary. A business may be required to pay back taxes, fines, and penalties. Criminal charges, though rare, can be brought against businesses by the worker, resulting in payments for lost benefits.
AB5 was signed in to law in the State of California on 9/18/2019. While only a state law, other states often view California as a leader in worker rights. AB5 expands on a state Supreme Court ruling and instructs businesses to use a stricter standard of proof in determining who is an employee, known as the “ABC test”. Workers will be considered employees of a business unless they are (a) free from the hiring company’s control, (b) doing work that isn’t central to the hiring company’s operations, and (c) operating an independent business in that industry.
For questions on proper classification of workers for tax purposes, consult your accountant or the IRS. For workers compensation classification questions, contact your Bankers Insurance agent. Not a client of ours? Let us compete for your business! Each client is assigned a personal agent in our office, given their email address, and provided a phone number that rings right on their desk.