Classifying an employee correctly makes a difference in how you pay them, what taxes are paid by who, and how you deduct worker-related expenses. An employer may pay an independent contractor and an employee for similar work, but there are important legal differences between them. Therefore, employers must accurately determine whether the people providing services are employees or independent contractors:
Employees work for an employer that controls the work of the employee, what will be done, and how it is done.
Independent contractors are workers who are in a trade or business that offers their services to the general public. Independent contractors are considered self-employed, and their earnings are subject to self-employment taxes (Social Security and Medicare). They often work under a registered business entity with a federal employer tax id number.
Independent contractor vs. employee
Whether a worker is an independent contractor or an employee depends on the relationship between the worker and the business. There are three things to consider when classifying a worker as an independent contractor or an employee:
- Behavioral control − Does the company control or have the right to control what the worker does and how the worker does the job?
- Financial control − Does the business direct or control the financial and business aspects of the worker’s job? Are the business aspects of the worker’s job controlled by the payer? Things like how the worker receives compensation or if expenses are reimbursed, who provides tools/supplies, etc.
- Relationship of the parties − Are there written contracts or employee benefits such as a pension, retirement savings plan, insurance, or vacation pay? Will the relationship continue, and is the work performed a key aspect of the business?
Source: Worker Classification 101: employee or independent contractor, IRS.Gov.
Misclassifying workers
Misclassifying workers adversely affects employees because if the employer’s share of taxes is not paid, the employee’s share is not withheld. If a business misclassifies an employee, it can be held liable for employment taxes for that worker- income taxes, Social Security and Medicare taxes, and unemployment taxes.
Because IRS and DOL rules differ, a worker may be classified as an employee under one rule and as an independent contractor under another rule. In some instances, it may be difficult for an employer to determine a worker’s status.
Another classification: the statutory employee
There is a third possible employment status for workers called a statutory employee (or non-employee). A statutory employee is a cross between an independent contractor and an employee. What makes this worker classification different is that outside of the company, they are treated as an independent contractor but as an employee for employment tax purposes and like an independent contractor for income tax purposes.
Why correct worker classification matters
Employees are paid as salaried or hourly and maybe a commission, and may be subject to additional compensation for overtime work. Employees are taxed and receive a W-2 form showing their annual income at tax time. As an employer, you must withhold the employee’s state and federal income taxes and FICA taxes (Social Security and Medicare). You also make FICA tax payments on their behalf for the employer’s part.
If you hire independent contractors, you do not withhold federal or state income taxes and FICA taxes from what you pay them unless they are subject to backup withholding because they failed to provide their tax ID number to you. Also, you are not required to make FICA payments for independent contractors. The independent contractor must pay these taxes on the payments they receive from your business.
Suppose you are not correctly classifying your workers. In that case, you may have to pay IRS and DOL penalties and all back taxes- state, federal, and FICA- due to inadequate employee classification. Your employees may also be subject to additional fines or taxes. Therefore, it is crucial to work with a PEO specialist like Aspen HR to determine if your company’s classification of workers is correct.
