James has worked with a young technology company almost from its inception. Initially the company was one of many clients.
Gradually, James spent more and more time working there and less on projects for other clients. Eventually, he was on-site pretty much every day and only rarely accepted small consulting jobs he could complete evenings and weekends.
Is James still a self-employed consultant? Or, from the perspective of the IRS, has he actually become an employee of the company?
The distinction between an employee and an independent contract may not be all that significant to the parties’ working relationship—but there’s a big difference when it comes to taxes. It affects federal income tax filings and various payments and withholdings of both the worker and the business—as well as Medicare and Social Security taxes and a range of benefits.
The IRS has stepped up enforcement and the consequences to a business discovered to be doing it wrong can be painful, potentially resulting in significant tax liabilities, as well as failing-to-file and failing-to-pay penalties. And many businesses are getting it wrong. Research indicates that small businesses typically misclassify 10 percent or more of their workers as contractors.
So, independent contractor or for-profit or not-for-profit employee? How do you determine if you’re a contractor or an employee? And if you’re an employer, are the contractors and consultants that work for you really employees?
Unfortunately, there is no single bright-line test. The basis for the determination is generally rooted in common law and various Supreme Court rulings, condensed by the IRS into three key considerations.
Considerations for Contractor-Employee Determinations
According to the IRS, for federal tax purposes, to distinguish between contractor and employee you “must examine the relationship between the worker and the business” with a focus on the “degree of control and independence” in the relationship. “The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”
In making a contractor-employee determination, the IRS considers the following three categories of evidence to be relevant:
Behavioral Control — the degree to which the business directs or controls the work. Does the business provide training? Does it provide detailed instructions governing when and how the work is actually performed, including such things as the equipment and supplies to be used or assistants to be hired?
Financial Control — the business and monetary aspects of the relationship, including the worker’s investment and ability to realize a loss. How is the worker paid for services and reimbursed for business expenses? Who provides necessary tools and equipment? Does the worker offers services to others?
Nature of Relationship — the perception of the relationship by the worker and business. Is there evidence of their intent? Are there consulting agreements, employment contracts or other written documents that define the relationship? Does the worker receive benefits typically provided to employees, such as vacation pay or health benefits?
If You’re Not Sure
If you’re still not sure of the appropriate classification after carefully evaluating these considerations, you can ask the IRS to make the determination for you. You’ll need to complete and file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
The determination can be requested by either a worker or a business.
If You’ve Misclassified Employees in the Past
Voluntary Classification Settlement Program (VCSE)
The IRS offers a Voluntary Classification Settlement Program for businesses that have mistakenly classified employees as contractors. The program applies to for-profit businesses, not-for-profit organizations and government entities.
You may be eligible for the program if you’ve consistently treated all of your workers—or a class or group of workers—as independent contractors. As a general rule, you must have filed all required 1099 forms for these workers for the past three years and you cannot be under audit by the IRS, the Department of Labor or a state agency with regard to employment taxes or employee classifications.
To apply for the program, file Form 8952, Application for Voluntary Classification Settlement Program at least 60 days before you intend to begin treating these workers as employees.
Under the terms of the program, you’ll have to pay 10 percent of the federal employment tax liability that would have been due for these workers for the most recent tax year.
In return, you won’t owe penalties or interest on this amount and you won’t be subject to an employment audit for the classification of these workers in prior years.
Voluntary Classification Settlement Program – Temporary Eligibility Expansion (VCSP TEE)
For those employers who are not VCSP-eligible because they haven’t filed the required 1099s, the IRS created a temporary expansion program which runs through June 30, 2013.
Under the terms of the program, you’ll have to pay 25 percent of the federal employment tax liability that would have been due for these workers for the most recent tax year.
In return, you won’t owe penalties or interest on this amount and you won’t be subject to an employment audit for the classification of these workers in prior years. However, you must file 1099s for all affected workers for the previous three years and pay a reduced penalty for not having filed the forms when originally due.