Employers have several tax obligations related to their employees. The government expects employers to withhold income taxes and social security and Medicare taxes from their employees’ pay in addition to paying unemployment tax on their wages. On the other hand, employers have no tax obligations on payments they make to independent contractors. Whether or not you use the services of independent contractors or employees depends entirely upon your business needs. You must know the difference between these two very different types of workers.
Basically, under common law rule, an independent contractor is someone who provides service to your business and whose method of working you cannot control. You only have the right to control or direct the result of his or her work. According to the IRS, you are working with an independent contractor when you cannot control what they do and how they do it. Anyone who performs a service for your business is an employee if you can control what they do and how they do it.
With the many different kinds of trades, services, and business arrangements available across the many industries in our market, some workers do not seem to fit perfectly into any one category of either employee or independent contractor.
Certain kinds of independent contractors may also be considered statutory employees for tax purposes, which complicates the issue even further. An example of this kind of service provider is a life insurance sales agent who works full-time and who chooses to sell life insurance or annuity contracts for one particular life insurance company. In the same vein, some workers may be considered statutory non-employees.
Determining the Type of Individuals Performing Services
Independent Contractor – A self-employed individual who performs a service or creates a product for a business, but the company cannot control or direct how they do the work, is an independent contractor. Typically doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, and auctioneers fall into this category.
Employee (common-law employee) – Anyone who performs services for a business, but the company controls what they do and how they do it, is considered an employee.
Statutory Employee – Even if workers are independent contractors under the standard law rules, such workers may still be treated as employees by statute for specific employment tax purposes. If they fall under one of four scenarios and meet three conditions under the Social Security and Medicare taxes, then you may still need to treat them as an employee for tax purposes.
- Drivers distributing beverages (other than milk) or meat, vegetables, fruit, or bakery products; or who pick up or deliver laundry or dry cleaning, if the driver is your agent or is paid on commission.
- A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.
- An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name if you also furnish specifications for the work to be done.
- A full-time traveling or city salesperson that works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer’s business operation. The work performed for you must be the salesperson’s principal business activity.
Social Security and Medicare Taxes
Employers should withhold Social Security and Medicare taxes from the wages of a statutory employee if all three of the following conditions apply:
- The service contract states or implies that substantially all the services are to be performed personally by them.
- They do not have a substantial investment in the equipment and property used to perform the services.
- The services are performed continually for the same payer.
Statutory Non-employee: Believe it or not, there are three categories of statutory non-employees, too: direct sellers, licensed real estate agents, and some companion sitters. The first two categories, direct sellers and real estate agents, are treated as self-employed for all federal tax purposes including income and employment taxes, if:
- Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked, and
- They perform these services under a written contract providing that they are not treated as employees for Federal tax purposes.
Conversely, companion sitters who are not employees of a companion sitting placement service are generally treated as self-employed for all federal tax purposes.
Government Worker: In most cases, individuals who serve as public officials are government employees. In this situation, the individual is an employee of the government, and the government entity is responsible for withholding and paying federal income tax, social security, and Medicare taxes.
Are you still confused?
There are generally three common-law categories that you can use to help you distinguish the type of business relationship you have with your worker and whether or not he or she is an independent contractor or an employee. They are behavioral, financial, and type of relationship – and they highlight the levels of control and independence in the business relationship.
Behavioral – Consider whether you have the right to control what your worker does and how he or she gets the job done.
Financial – Do you control all the business aspects of the job, such as supplying tools and materials, or deciding how the worker is paid, and whether or not expenses are reimbursed?
Type of relationship – Are there written contracts or benefits established, such as a pension plan, leave pay, or insurance? Is it an ongoing relationship that facilitates an essential service to the business?
While the IRS provides extensive guidance on determining a worker’s status, there is no strict black and white, easy-delineation; you are encouraged to look at the entire business relationship to come to an understanding. If you still have doubts after you have investigated the situation thoroughly, you can get help from the IRS by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. The IRS will look over the data and officially identify the worker’s status for you.
If you’re still unsure, it may be time to solicit the assistance of a small business advisor. Reach out to us here and one of our staff will be happy to sit down with you to discuss how we can help your small business flourish.
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