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Workers you hire to perform tasks for your organization can be either independent contractors or employees. Understanding the difference between these two classifications is critical to your relationship with the workers — and to your tax reporting.

Is a worker an employee or an independent contractor?

Determining whether a worker is an employee or an independent contractor can be challenging. The IRS considers the following three categories to make this determination:

  • Behavioral control: When the business has the right — whether or not it’s exercised — to direct and control the work the individual performs, the individual is an employee. The various behavioral control categories include:
    • The types of instructions. Instructions on where and when to work, what tools to use, and where to purchase services and supplies indicate an employee.
    • The degree of instruction. Less detailed instructions may indicate that the individual is an independent contractor, while more detailed instructions may indicate that the person is an employee.
    • Evaluation systems. Systems that evaluate how the work is done indicate the individual is an employee, whereas evaluation systems that measure only the end result point to an independent contractor.
    • Training. Independent contractors usually take care of their own training, whereas training a worker on how to do the job or providing periodic or ongoing training about methods and procedures indicates an employee.
  • Financial control: When the business has a right to control the business and financial aspects of the worker’s job, the individual is likely an employee. To determine this, consider:
    • Who makes the significant investment in the equipment the individual uses when performing the work for the business? If the individual does this, they’re probably an independent contractor.
    • Having the opportunity for profit or loss based on the work performed indicates the individual is an independent contractor.
    • When the individual makes unreimbursed expenses, they’re more likely to be an independent contractor.
    • If the individual is free to make their services available to the market, it may indicate they’re an independent contractor.
    • If the individual is guaranteed a regular wage amount for an hourly, weekly, or another period of time, even when supplemented by a commission, they’re more likely to be an employee.
  • Relationship: How the business and the worker perceive their interaction with one another determines the relationship. This includes:
    • Benefits. Businesses generally don’t provide benefits for independent contractors, whereas employees may receive insurance, a pension plan, PTO, and sick pay.
    • A written contract that describes the intended relationship. Note, however, that a contract is not sufficient to determine whether the worker is an employee or an independent contractor.
    • The performed services. Are the services the worker performs a key activity of the business?
    • The permanency of the relationship. When the relationship is expected to continue indefinitely, it may indicate that the individual is an employee.

Potential penalties for treating an employee as an independent contractor

Unless you have a reasonable basis for classifying an employee as an independent contractor, you could be held liable by the IRS for that worker’s employment taxes.

A worker who believes you classified them as an independent contractor without reasonable basis can file Form 8919 to report their share of uncollected Medicare and Social Security taxes due on their compensation.

However, if you can provide a reasonable basis for not treating a worker as an employee, you may, if you meet certain conditions, be relieved from having to pay that worker’s employment taxes. To qualify for this relief, you must not have treated any worker in a substantially similar role as an employee for any period of time after 1977. In addition, you must file every federal information return on a basis that is consistent with your treatment of the worker.

The Voluntary Classification Settlement Program (VCSP) offers an opportunity to reclassify workers as employees for future tax periods for employment tax purposes with partial relief from federal employment taxes for eligible taxpayers that agree to treat their workers as employees. To apply for the VCSP, you must meet certain eligibility requirements and file Form 8952.

Be aware of how you treat your workers

Misclassifying your workers as independent contractors can result in a lot of headaches with the IRS and being held liable for employment taxes. In addition, it can have a negative impact on your employer brand. To avoid misclassification, review how you treat your workers regularly, and seek the advice of a professional in the event you have any questions at all.