Distinguishing Employees From Independent Contractors for Tax Purposes
For tax purposes, each worker in the U.S. economy is either an employee or an independent contractor. The basic concept is that an employee works for someone else, while an independent contractor runs their own business, but the distinction is not always clear. However, the difference is critical because independent contractors do not receive the same benefits and rights as employees. Employers thus have an incentive to classify an individual as an independent contractor whenever possible, which means that employees are often misclassified as independent contractors. As a result, taxing authorities at the federal and state levels miss out on many payroll taxes that they should receive.
The IRS devotes substantial efforts to identifying misclassification of employees. A business that is found to have misclassified an employee may be required to pay the employment taxes that should have been due, in addition to penalties. In deciding whether a worker is misclassified, the IRS will consider whether the business has the right to direct and control the worker. This means that the business can dictate not only the final product but also the manner in which the work is completed. If it can, that person is an employee. If the business does not have the authority to control how the worker does the job, that person is an independent contractor. It is important to be aware that the test considers authority to control, rather than actual control. Even if the business does not actually tell a worker how to do the job, the worker is an employee if the business has the right to tell the worker how to do the job.
Factors in the Right to Control Test
The IRS will consider circumstantial evidence in determining whether an employee has been misclassified. It divides aspects of control into behavioral control, financial control, and the relationship between the business and the worker. Behavioral control means that the business trains the worker and gives them instructions for how to complete the job. Financial control means that the business provides the tools, equipment, and physical space for doing the job, the worker does not advertise their individual services to the public, the worker is paid for their time rather than the result, and the business covers expenses related to the job.
The last factor involves considering whether the worker receives employee benefits, whether they can be fired or resign at any time, whether their work is closely tied to the standard products or services offered by the business, and whether they have a client agreement with the business. In many cases, some of these factors will point toward classifying a worker as an employee, while others will point toward classifying a worker as an independent contractor. If you are in doubt, you may want to consult a lawyer or a tax professional so that you do not fail to pay employee taxes and find your business burdened with back taxes and penalties. For situations in which there is no clear answer, the safer course of action is always to assume that a worker is an employee.