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Independent Contractor or Employee?

TaxAlerts Tax Article

January 2012 | Written by: Karen Reed, EA

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If you hire or contract with individuals to provide services to your business, it is important to correctly determine whether each person is an employee or independent contractor. This determination will be the basis for how you treat the payments you make to them for their services. The consequences of misclassifying workers can be costly and may include back payments of employment taxes as well as penalties of as much as 100% and interest to both federal and state taxing agencies. Beginning in 2012, the State of California has the authority to assess penalties as high as $15,000 for each improperly classified worker, with matching penalties assessed against the business’s advisors. Other states are expected to follow suit.

The classification of workers depends on the degree of your control over the worker and the independence of the worker. The factors that need to be considered are the extent to which you control the workers and how they do their jobs, whether or not you provide the tools and supplies needed for the work, and whether or not there are written contracts and/or benefits, such as insurance, retirement plans and vacation pay. Generally, when you as the company owner control what the worker does and provide the tools necessary to perform the work, the worker is considered to be your employee rather than an independent contractor.

At the federal level, employers that are able to show a reasonable basis for not treating a worker as an employee may qualify for relief under Section 530. To establish a reasonable basis, the employer would need to show that one of the following situations applies:

  • Reliance on a court case or IRS ruling
  • An IRS audit commenced before 1997 during which the IRS did not reclassify similar workers not treated as employees
  • An IRS audit after December 31, 1996, that included an employment tax examination during which similar workers were not reclassified
  • A significant segment of their industry treats similar workers as independent contractors
  • Reliance on some other reasonable basis, such as the advice of a business attorney

In addition, the employer must also have treated the workers and any similar workers as independent contractors and filed all required federal tax and information returns consistent with their treatment of their employees.

There are major differences in how payments are treated for employees versus independent contractors. For all of your employees you will be required to withhold income taxes, withhold and pay FICA (Social Security and Medicare) taxes, as well as pay unemployment tax on wages paid to employees. To avoid penalties, be sure to take the steps needed to correctly classify the individuals providing services to your business.