Businesses often boost their workforce by hiring independent contractors to perform skill-specific, short-term, or project-based tasks. They do this for a number of reasons such as cost savings, short term lack of employees, reduction of employers’ liabilities, or greater flexibility compared to hiring an employee.
However, employers need to take care when classifying workers as independent contractors as opposed to employees. In case of independent contractor misclassification, they can face strict and costly civil and criminal penalties. Also, employees who are misclassified as independent contractors can sue businesses for benefits they were denied, such as health insurance, overtime pay, and the minimum wage. Due to serious risks and consequences, it is essential that organizations have a defined program in place for avoiding independent contractor misclassification.
Differences between Employees and Independent Contractors
In order to prevent independent contractor misclassification, employers need to make a distinction between employees and independent contractors. Among the most significant differences between them are payments and taxes.
An independent contractor provides a good or service to another individual or business, usually under the terms of a contract. The contractor retains control over how they provide the good or service and is not subject to the employer’s control or guidance. Essentially, independent contractors often have multiple clients, are self-employed, pay their own taxes and provide their own benefits. On the other side, an employee is hired under an employment agreement. Employers withhold taxes from their wages, may provide benefits, and pay employment taxes for them.
Forms W-2 and 1099-MISC
Although forms W-2 and 1099 are both information wage statements, the purposes they serve and the types of worker classification they represent are different.
Form W-2 is a wage and tax statement employers issue to employees. This form includes information for the tax year about taxable income for the employee, Social Security, Medicare and FICA taxes, and state income taxes withheld from the employee’s paycheck.
Form 1099-MISC is used for miscellaneous income paid to non-employees, such as independent contractors. Earnings from independent contractors are also subject to self-employment tax. Form 1099-MISC is used to report payments of $10 or more in gross royalties or $600 or more in rents or compensation, to both the IRS and the individual who received the payment.Use this comprehensive guide to successfully manage tax responsibilities, remain compliant with complex and ever-changing regulations, and avoid hefty penalties.
Determining Who Is an Independent Contractor
It can be difficult for employers to draw a distinction between employees and independent contractors. The IRS provides guidance about how to correctly classify workers, and considers three major categories in determining whether they are employees or independent contractors:
- Behavioral – Employers need to determine if their company controls workers as well as how they do their job.
- Financial – It is necessary to establish who controls the economic aspects of the worker’s job and what the method of payment is.
- Type of Relationship – Other important aspects are the length and terms of a relationship with a worker, as outlined in a contract, employment agreement, and other documentation.
In case that employers are unsure how to classify their workers and want to prevent independent contractor misclassification, they can file Form SS-8 with the IRS. In that case, the IRS will make a determination, but it can take up to six months to decide.
Independent Contractor Misclassification
It is critical that employers classify workers correctly since independent contractor misclassification can result in costly financial penalties.
Employee misclassification happens when workers are mislabeled as independent contractors, rather than employees. Independent contractor misclassification prevents workers from having benefits and protections, such as the minimum wage, overtime compensation, family and medical leave, unemployment insurance, and safe workplaces. Furthermore, such misclassification results in significant losses to the federal and state government in the form of lower tax revenues.
Due to independent contractor misclassification, the IRS and Department of Labor (DOL) can impose hefty penalties. Penalties may be assessed against an employer for failing to withhold state and federal payroll taxes, including failure to make matching Social Security and Medicare tax payments. Also, penalties may be increased in cases where an employer’s actions are deemed intentional.
Employees misclassified as independent contractors may be entitled to coverage under the company’s employee benefit plans, including pension and other retirement plans, health insurance, paid leave, and severance pay among others.
Taking Necessary Steps to Avoid Penalties
According to the IRS, if the worker is an employee, employers have to withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. Also, employers do not generally have to withhold or pay any taxes on payments to independent contractors.
However, in the case of independent contractor misclassification, employers risk increased tax bills and penalties for not paying the appropriate employee taxes and using the wrong form. They may also be subject to penalties for failing to take appropriate state withholding and deductions, plus levies for not making contributions to state disability and unemployment agencies.
Therefore, it is critical that employers have a clear understanding of the business relationship between them and their workers. The IRS provides important information regarding this relationship in order to help businesses make the correct classification. In addition to this, companies can consider outsourcing tax management. This can allow them to optimize tax form processing and obtain pertinent information about employees necessary to avoid independent contractor misclassification. As a result, employers can ensure compliance with ever-changing tax laws and regulations, and prevent any tax errors and the resulting penalties.Introduce technology to tackle increasingly complex tax compliance successfully and free up your tax department to focus on other priorities while still generating high-quality returns efficiently and economically.