Employees vs. Contractors: Understanding Your Business Obligations
One major struggle that most contractors face is an ongoing challenge of deciding how to categorize the workers they hire. Should they be deemed employees or contractors? Unfortunately, the answer to this question usually comes down to which categorization costs less.
The IRS has strict guidelines used to determine the category assignment.
In this article we will explore the guidelines used by the IRS to make this determination and the obligations businesses have to their employees and contractors. For the sake of simplicity, we will refer to contractor employers as "businesses" and the "workers" will be those who are referred to as either "employees" or "contractors."
Within the IRS publication 5520 (S-2021), How Businesses Determine if a Worker is an Employee or Contractor, the IRS identifies three main areas that must be examined to assist in making the determination: Behavioral Control, Financial Control, and Relationship.
Behavioral Control
In this area, the IRS seeks to determine the level of control the business has over the worker. Is the business directing the worker what to do and when to do it? Are they training the worker on what needs to be done to accomplish the assigned tasks? Do they have an evaluation system by which they give feedback to the worker? If the answers to these questions are “yes”, then the worker is an employee.
However, if the business hires a worker and does not have that level of oversight (as previously described), additional questions come into play. Does that new hire have the knowledge, skillset and tools needed to accomplish the assigned task? If that worker is not being supervised by the business because they are a professional in that area in their own right, and have a demonstrable history of accomplishing similar tasks, then that worker has passed one of the areas which deems it necessary to consider them a contractor.
Financial Control
Under this area, the main question* asked by the IRS is “Does the business have the right to control the economic aspects of the worker’s job?” The questions asked include the following:
• Does the business have an influence on who the worker’s company markets to and accepts as a customer, or can they potentially wield this influence?
• Has the worker made a significant investment in their operations, such as incorporating, purchase of equipment, marketing, hiring of professionals?
• How is the worker paid?
• Does the worker prepare and submit an invoice for work performed, or do they clock in to register their time and get paid based on the time tracking system?
If the business does not have any influence on how the worker operates their company, and/or if that worker advertises their services and has other clients, then under the financial control area standards, that worker can be considered a contractor.
Relationship
How do the worker and business see their relationship with each other? If the worker and the business have a written agreement for a fixed (predetermined) period of time, but lacking employee benefits, then that doesn’t automatically make the worker an employee. The key determinant is the control the business exercises over the worker, regardless of what it is called in the agreement.
If the employer has the right to control the work done by the worker, (including how and when it is completed), the worker is likely to be considered an employee, even if they were hired as an independent contractor.
Business Obligations to Employees and Contractors
Businesses have stringent obligations regarding their obligations to their employees. They are required to withhold federal taxes and FICA from employees’ wages every pay period and submit those payments to the federal government according to their deposit requirements.
In addition to those payments the business is required to match the employee’s FICA payments (7.65%) and federal unemployment taxes are paid annually on the first $7,000 of each employee’s gross pay.
The federal taxes withheld in addition to the employees’ and employer’s FICA contribution are generally reported quarterly on a Form 941, but can also be reported on a Form 944 if the annual amount is less than $1,000. Federal unemployment is reported annually on Form 940.
Contractors on the other hand are paid an agreed-upon price for services that should ideally be outlined in a contract between the contractor and the business. The business generally does not withhold any amount from the contractor’s payment unless there is a valid reason for doing so (such as a breach of contract) or unless the contractor specifically requests it (for example, in the case of Federal Income taxes). Even then, the business is not obligated to grant the request.
The business is required to report amounts paid of $600 or more to contractors annually on a form 1099-NEC. The form must be sent to the contractor and IRS by January 31 of the following year. There are penalties and interest imposed for the failure to send the 1099-NEC to the contractors and IRS by the deadline.
Considerations
It is important that businesses should take these three areas into consideration when determining workers’ classifications: behavioral control, financial control, and the relationship that exists between them in a written agreement or otherwise.
If a business considers certain workers contractors, when according to the factors mentioned they should actually be considered "employees," the IRS has the ability to re-categorize those workers as employees. The business would then be responsible for the federal taxes and FICA payments the employees would have been subject to, along with their required FICA and unemployment taxes. Penalties and interest will be imposed on these balances.
It is crucial for businesses to assess every hire based on the IRS guidelines in order to avoid the issues that arise with mis-categorizing employees as contractors.
*Question taken directly from the IRS Publication