Every time you hire paid help in your business, you need to make an important distinction: is the worker an employee or an independent contractor? This classification is important because it determines which taxes get paid, when they get paid, and by whom. Misclassifying employees as independent contractors results in heavy penalties.
The IRS recognizes four classifications of workers:
- Independent Contractor
- Statutory Employee
- Statutory Non-Employee
Most commonly, small business owners deal with employees and independent contractors. Let’s take a closer look at what is required of you when paying each:
If your worker is classified as an employee, you’ll need to withhold, deposit, report, and pay employment taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid.
The IRS also requires that you give certain forms to your employees, collect certain forms from your employees, and send certain forms to the IRS and the SSA.
If you don’t correctly withhold or pay the required amounts, the IRS may flag your business and come after any money owed. In addition, not withholding taxes and benefits (or incorrectly withholding them) also puts an undue burden on the employee.
If your worker is classified as an independent contractor, you aren’t required to do as much legwork. Independent contractors arrange and pay their own income tax.
In addition to paying the contractor, the IRS requires you to arrange for the contractor to receive Forms W-9 and 1099-MISC.
But how can you know who’s which?
The IRS has set up some general criteria to help business owners distinguish between employees and independent contractors. When you need to classify a worker, there are three factors to consider:
The degree to which an employer exercises control over the worker’s time, working habits, or tools can affect the status of the worker. If the employer trains the worker and directs the work, sets specific hours, and dictates how the work will be completed, the individual in question will likely be designated as an employee.
On the other hand, if the worker sets their own hours and decides how and when to get the work done, they are likely an independent contractor. If you are planning on hiring an independent contractor, be aware that only the result of the work will be under your control. You will not be able to dictate the way that the work is carried out.
If the worker is paid on salary or by the hour, they are likely to be designated as an employee. If the worker is paid a flat fee per job or project, they’re more likely to be an independent contractor.
Also, if the worker is allowed to work with other businesses in conjunction with yours, or if they could potentially incur a profit or loss from the activity they are conducting for your business, they are likely an independent contractor.
Type of Relationship
The type of relationship that exists between the worker and the business owner also affects how they’re classified. If the work being done is directly related to the company’s core work, then the worker is probably an employee. Alternatively, if the worker is providing a service that is on the periphery of the business, they could be designated as an independent contractor.
For example, if you run a coffee shop and you hire a graphic designer to create new menus and business cards, you are most likely hiring an independent contractor. If you’re hiring a barista to make delicious coffee for your customers five days a week, you’re almost certainly hiring an employee.
What Form to File
As a business owner, you’ll need to file different tax forms depending on whether you hire an employee or an independent contractor.
You’ll need to arrange a Form W-9 and file Form 1099-MISC for each independent contractor you work with to whom you pay $600 or more during the tax year.
For each of your employees, you’ll need to file a Form W-2, as well as withhold and pay certain taxes and benefits.
How Does Misclassification Happen?
Although hiring an employee can work wonders for the growth of a business, doing so tends to be a greater financial and administrative burden.
Whereas independent contractors withhold and pay their own taxes, employers are required to withhold certain taxes and pay benefits to each of their employees.
Employers misclassify employees as contractors in order to avoid paying the taxes and benefits they should be taking care of for their employees. The IRS won’t stand for that, and they’re quick to penalize businesses who misclassify workers — intentionally, or otherwise.
The Consequences of Misclassifying Employees
In the event that the IRS finds a business to be misclassifying employees as independent contractors, the business would need to pay back-taxes as well as penalties for income taxes, Social Security, Medicare, and unemployment taxes.
Depending on the position, the employer may also need to provide the newly designated employee with their rightful benefits.
Knowing how to classify workers is an essential skill for every entrepreneur. Get it right and you can rest easy knowing that your business complies with IRS requirements.