Is your business growing to the point where you’re having to hire people to work for you?
Fantastic. Congrats. Sending you a virtual slap on the back!
Now, listen up, because this is no joke.
If you misclassify a worker as an independent contractor (self employed) when, legally, he or she is an employee in the eyes of the law, then you could be penalized in ways that will not only hurt your bank account, but will slam your reputation.
Not knowing the difference between hiring an employee (IRS Form W2) vs. independent contractor (IRS Forms W9 and 1099) has been costly to many an online business owner.
Financial consequences aside (hefty fines starting at $5,000 and having to pay employment taxes), you simply do not want to mess with the IRS, and in many cases, you don’t want to mess with state laws that can be even more unforgiving when employers don’t comply with the law.
Look At The Facts
Facts that provide evidence of the level of control an employer has over a worker vs. the amount of independence the worker has, fall into three categories:
Behavioral: How much control does the worker have over how she performs the job?
Financial: Does the company control any of the business aspects of the worker’s job, such as method of pay, reimbursement of expenses, or whether the worker uses the employer’s tools and supplies or brings his own to the job site.
Type of Relationship: Is the relationship between the company and the worker permanent or temporary and are there there written contracts? Are there benefits such as a pension plan, paid time off, or health insurance?
Whether the company actually asserts control is not the issue; it’s whether the company has the right to control the worker that is a major determining factor.
IRS Form W-9
If you’ve made the determination that the person you’re paying is not an employee but rather an independent contractor, the first step is to have the contractor complete Form W-9, or the Request for Taxpayer Identification Number and Certification form. This form can be used to request the correct name and Taxpayer Identification Number, or TIN, of the worker. A TIN may be either a Social Security Number (SSN), or an Employer Identification Number (EIN).
NOTE: Keep the W-9 in your files for 4 years in the event of any questions from the worker or the IRS.
IRS Form 1099-MISC
Form 1099-MISC is most commonly used by payers to report payments made in the course of a trade or business to others for services.
If you paid someone who is not your employee, such as a subcontractor, attorney or accountant $600 or more for services provided during the year, a Form 1099-MISC needs to be completed, and a copy of 1099-MISC must be provided to the independent contractor by January 31 of the year following payment. Starting last year (2016), the “PATH Act” (Protecting Americans from Tax Hikes) moved up some 1099-MISC filing deadlines to January 31. The new law makes it easier for the IRS to find and stop refund fraud.
There are certain situations where a 1099 is not required. These exceptions are listed in the 1099 Instructions.
IRS Form SS-8
After reviewing the facts, if you’re still not clear whether the person you’ve hired would be considered an employee or an independent contractor, refer to Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, which can be filed (either by the company or the worker) with the IRS. The IRS will then make a determination of the worker’s status. Be careful here, as some tax specialists caution that IRS will often classify workers as employees whenever their status is not clear-cut. Also, employers that request an IRS determination lose certain protections against liability for misclassification.
In some states, the laws are tougher than those of the IRS. Check with your state laws to ensure you’re in compliance. California is considered among the strictest.
THE 20-FACTOR “RIGHT TO CONTROL” TEST
IRS examiners use a 20-point test to help determine whether a worker is to be classified as an employee or an independent contractor, depending on how much control a company has over a worker; the more control, the more likely the classification is to be that of employee (a.k.a., the “right to control” test).
These are guidelines and individual circumstances must be taken into account. If you answer YES to all of the first 4 questions, the classification is more likely to be that of independent contractor.
The more you answer YES to any of questions 5 through 20, the more likely your worker is going to be consider an employee.
1. Possibility of Profit or Loss
Can the worker make a profit or suffer a loss as a result of the work, notwithstanding the predetermined money he/she would make from completing the project?
2. Investment in Tools and Supplies
Does the worker own or have an investment in the equipment, tools, supplies and/or the facilities used to do the work?
3. Works for More Than One
Does the worker work (or is he able to work) for more than one company at a time? Of course, “employees” can work for more than one employer, but people who simultaneously provide services for several unrelated companies are likely to qualify as independent contractors.
4. Services Available to the General Public
If a worker makes his or her services available to the general public on an ongoing basis, this tends to support a determination of independent contractor status.
5. Instructions and Right to Control
Does the employer have the right to dictate instructions when it comes to when, where, and how to work? (This shows control over the worker’s ability to make such decisions.)
Does the worker need training to do the job in a particular way? (Independent contractors are expected to be already trained.)
7. Degree of Integration
Are the worker’s services so integral to the company’s business operations that the success of the company is greatly impacted by their role/contribution? (This may show that the worker is subject to your control.)
8. Who Performs the Services
Must the worker himself provide the services personally, as opposed to delegating tasks to someone else? Companies that insist on a particular person performing the work assert a degree of control that suggests an employment relationship. In contrast, independent contractors typically are free to assign work to anyone.
9. Hiring/Paying Assistants
Does the company hire, supervise, and pay the worker’s assistants? (Independent contractors hire and pay their own staff.)
10. Continuing Relationship
Is there an ongoing relationship between the worker and the company? A relationship can be considered ongoing if services are performed frequently, even if irregularly. However, an independent contractor arrangement can involve an ongoing relationship for multiple, sequential projects.
11. Work Hours and Schedule
Does the company set the worker’s hours? People whose hours or days of work are dictated by a company are more apt to qualify as its employees. Independent contractors, by contrast, are in control of when they do the work.
12. Full-Time Work
Must the worker spend all of his or her time on your job? Full-time work gives a company control over most of a person’s time in any given week, which supports a finding of an employment relationship. Independent contractors choose when and where they will work.
13. Where Work is Performed
Must the individual work on the company’s premises or does the company control the route or location where the work must be performed? Requiring someone to work on company premises, especially if the work can be performed elsewhere, indicates a possible employment relationship.
14. Sequence of Work
Does the company have the right to determine the order in which services are performed? If a company requires work to be performed in a specific order or sequence, this suggests an employment relationship.
15. Requirement for Reports
Must the worker give the company reports accounting for his or her actions? If a worker must regularly provide written or oral reports on the status of a project, this arrangement indicates a possible employment relationship because it would tend to show lack of independence.
16. Pay Scheduling
Does the company pay the worker by hour, week, or month? Hourly, weekly, or monthly pay schedules are characteristic of employment relationships, unless the payments simply are a convenient way of distributing a lump-sum fee. Payment on commission or project completion is more characteristic of independent contractor relationships however by industry practice, some are paid by the hour.
Does the company pay the worker’s business or travel costs? Independent contractors typically bear the cost of travel or business expenses, and most contractors set their fees high enough to cover these costs. Direct reimbursement of travel and other business costs by a company suggests an employment relationship.
18. Tools and Materials
Does the company provide the worker with equipment, tools, or materials? Workers who perform most of their work using company-provided equipment, tools, and materials are more likely to be considered employees. Work largely done using independently obtained supplies or tools supports an independent contractor finding.
19. Right to Fire
Can the company fire the worker? A company’s unilateral right to discharge a worker suggests an employment relationship. By contrast, a company’s ability to terminate independent contractor relationships generally depends on contract terms, i.e., an independent contractor can’t be fired without subjecting the company to the risk of a breach of contract lawsuit.
20. Worker’s Right to Terminate
Can the worker quit at any time, without incurring liability? Most employees unilaterally can terminate their work for a company without liability. Independent contractors cannot terminate services without liability, except as allowed under the contract.
Bottom line: Business owners, make sure you know the law. Speak to your accountant and make sure not to misclassify the status of the people you hire. It can get ugly if a worker decides to make a claim of “employee” status.
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