Correctly classifying employees vs. independent contractors is key to avoiding trouble with the IRS. Below, we’ve covered the common details regarding employees and independent contractors every employer needs to know.
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There are many potential differences between employees and independent contractors. But the primary difference (and the difference that matters to the IRS) has to do with how much control a worker has over the work they do.
Control, in this case, can be thought of alongside independence. How free is the worker to complete the assigned work as they wish? Who is in charge of the details—the business or the worker?
As a general rule, the more an employer controls a worker, the more likely the worker is an employee. But this is not necessarily true in every situation, and there are many other factors that can help determine a worker’s employment status.
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The main reason it’s important to correctly identify a worker as an employee or independent contractor is for tax purposes.
As an employer, you are responsible for paying a portion of your employees’ payroll taxes. Employers are not responsible for paying any of an independent contractor’s income-related taxes—independent contractors must pay their own.
If a worker is treated as an independent contractor when they should have been treated as an employee, the employer could be held liable for the employment taxes that went unpaid.
Businesses need to weigh numerous factors when determining whether a worker is an employee or independent contractor. There is no magic or set number of factors that classifies the worker one way or the other, and no one factor stands alone in making this determination. Keep in mind, too, that relevant factors may vary by situation.
The keys are to look at the entire relationship, consider the degree or extent of the employer’s right to direct and control, and to document each of the factors used in coming up with the determination—issues we’ll cover in detail in the sections below.
The amount of control a worker has over their work helps the IRS figure out if they’re an employee or independent contractor.
The IRS uses three general factors to determine worker control: Behavioral Control, Financial Control, and Type of Relationship. When you’re figuring out a worker’s status, you can use these factors, too.
Behavioral control determines if an employer has a right to direct how a worker does their assigned work. The existence of behavioral controls can indicate that the worker is an employee.
The IRS further defines behavioral control via four categories: type of instruction, degree of instruction, evaluation systems, and training.
An employer has financial control if they can dictate the monetary details of a worker’s job. Per the IRS, financial control factors include: significant investment, unreimbursed expenses, opportunity for profit or loss, services available to the market, and method of payment.
Type of relationship is determined by how workers and businesses understand the nuances of their arrangement. The IRS identifies four worker/business relationship factors: written contracts, employee benefits, relationship permanency, and services provided as key business activity.
Note, however, that it can be more difficult to classify workers as independent contractors in some states than in others. California, for example, changed its independent contractor rules in 2020 with law AB5. To qualify as an independent contractor in that state, you must pass the “ABC test.” The test says you’re only an independent contractor if you’re free from control, do types of work outside the business’s typical purview, and have a separate business of your own.
No matter what kind of workers you have, you need to submit the proper tax documents to them and to the IRS.
Employees need to receive form W2. You’ll send copies to the IRS as well.
Independent contractors need to receive form 1099-NEC. (Form 1099-MISC was the required filing until 2020.) Just like with W2s, you’ll also send copies to the IRS.
The deadline for distributing tax forms to both employees and independent contractors is January 31. If January 31 falls on the weekend or a holiday, the deadline is the next business day.
You’ll pay a fee. How big of a fee depends on how late you are. (The fees are the same whether you’re filing W2s or 1099s.)