When you hire Independent Contractors, you want to make sure you are avoiding misclassification. A business that classifies its employee as an Independent Contractor but fails to meet all the regulatory requirements can be subject to a government tax audit or lawsuits.
According to the Harvard Business Review, the use of Independent Contractors has increased by 40% in the last decade. According to the Labor Department, so many employees are misclassified because companies are not knowledgeable about how to classify their employees according to labor and workplace laws. The issue of misclassification of Independent Contractors has been around for a while. According to the IRS, they primarily view workers as Independent Contractors when they should be classified as W-2 Employees.
In every business, you have your regular W-2 employees, and the company will take out payroll taxes and pay that amount to the IRS for each pay period. At the end of the year, the employee will receive their W-2 and will then pay additional taxes to the government or receive a refund.
However, when a business classifies an employee as an Independent Contractor (IC), payroll taxes are a little different. The business pays the IC a gross amount, and then the IC is responsible for making their own tax deposits to the IRS. The company is responsible for reporting payments made to the IC to the government. This will be done using the form 1099 NEC at the end of the year with copies sent to the recipient, the Federal government, and the States that require 1099 NEC reporting.
The IRS has categorized three groups that will help determine if an employee is a W-2 or an Independent Contractor.
- Behavioral Control: Does a company control what the worker does and how they do their job?
- Financial Control: How is the worker paid? Do they do expense reimbursement?
- Type of Relationship: Are there written contracts or employee-type benefits?
According to the IRS and court precedent, the following items indicate that a worker is an employee:
- Level Of Instruction: If the company directs when, where, and how work is done, this control indicates a possible employment relationship.
- Degree of Business Integration: Workers whose services are integrated into business operations or significantly affect business success are likely to be considered employees.
- Services Rendered Personally: Companies that insist on a particular person performing the work assert a degree of control that suggests an employment relationship.
- Set Hours Of Work: People whose hours or days of work are dictated by a company are apt to qualify as its employees.
- Full-time Required: Full-time work gives a company control over most of a person’s time, which supports a finding of an employment relationship.
- Furnishing Tools and Materials: Workers who perform most of their work using company-provided equipment, tools, and materials are more likely to be considered employees.
According to the IRS and court precedent, the following items indicate that a worker is a contractor:
- Investment In Facilities: Independent contractors typically invest in and maintain their own work facilities.
- Realization Of Profit Or Loss: A worker who can realize a profit or suffer a loss providing the services is generally an independent contractor.
- Working For More Than One Firm At A Time: People who simultaneously provide services for several unrelated companies are likely to qualify as independent contractors.
- Making Service Available To The General Public: If a worker makes his or her services available to the public on a regular and consistent basis, that indicates independent contractor status.
- Hiring, Supervision, & Paying Assistants: If the worker hires and supervises others under a contract pursuant to which the worker agrees to provide material and labor and is only responsible for the result, this indicates independent contractor status.