Before you can determine how to treat the payments your business makes for services, you must first know the business relationship that exists between you and the person performing the services. The person performing the services may be:
An independent contractor; A common-law employee; A statutory employee; A statutory nonemployee.
In determining whether the person providing service is an employee or an independent contractor, consider all information that provides evidence of the person’s degree of control and independence.
It is critical that you, the employer, correctly determine if the individuals providing services are employees or independent contractors. Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors.
Caution: If you incorrectly classify an employee as an independent contractor, you can be held liable for employment taxes for that worker, plus a penalty. This liability can be substantial, depending on how many workers and tax years are at issue.
Who is an independent contractor?
The general rule is that you, the payer, have the right to control or direct only the result of the work done by an independent contractor, and not the means and methods of accomplishing the result.
Example: Vera Elm, an electrician, submitted a job estimate to a housing complex for electrical work at $16 per hour for 400 hours. She is to receive $1,280 every 2 weeks for the next 10 weeks. This is not considered payment by the hour. Even if she works more or less than 400 hours to complete the work, Ms. Elm will receive $6,400. She also performs additional electrical installations under contracts with other companies, which she obtained through advertisements. Thus, Vera is an independent contractor.
How should I report payments made to independent contractors?
You may be required to file information returns to report certain types of payments made to independent contractors during the year. For example, you must file IRS Form 1099-MISC, Miscellaneous Income, to report payments of $600 or more to persons not treated as employees (e.g., independent contractors) for services performed for your trade or business. For details about filing IRS Form 1099 and for information about required electronic or magnetic media filing, refer to Information Returns Processing.
Who is a common-law employee?
Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.
To determine whether an individual is an employee or independent contractor under the common law, the relationship of the worker and the business must be examined. Consider all evidence of control and independence. In an employee-independent contractor determination, all information that provides evidence of the degree of both control and independence must be considered.
Facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties. Refer to IRS Publication 15-A, Employer’s Supplemental Tax Guide, for additional information.
Who is an employee?
A general rule is that anyone who performs services for you is your employee if you can control what will be done and how it will be done.
Example: Donna Lee is a salesperson employed on a full-time basis by Bob Blue, an auto dealer. She works six days a week, and is on duty in Bob’s showroom on certain assigned days and times. She appraises trade-ins, but her appraisals are subject to the sales manager’s approval. Lists of prospective customers belong to the dealer. She has to develop leads and report results to the sales manager. Because of her experience, she requires only minimal assistance in closing and financing sales and in other phases of her work. She is paid a commission, and is eligible for prizes and bonuses offered by Bob. Bob also pays the cost of health insurance and group-term life insurance for Donna. Thus, Donna is an employee of Bob Blue.
If workers are independent contractors under the common law rules, such workers may nevertheless be treated as employees by statute (statutory employees) for certain employment tax purposes, if they fall within any one of the following four categories and meet the three conditions described under Social Security and Medicare Taxes, below:
A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission. A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company. An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done. A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer’s business operation. The work performed for you must be the salesperson’s principal business activity. Refer to the Salesperson Section of Publication 15-A, Employer’s Supplemental Tax Guide, for additional information.
There are two categories of statutory nonemployees: direct sellers and licensed real estate agents. They are treated as self-employed for all Federal tax purposes, including income and employment taxes, if:
1. Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked, and
2. Their services are performed under a written contract providing that they will not be treated as employees for Federal tax purposes.
Refer to information on Direct Sellers located Publication 15-A, Employer’s Supplemental Tax Guide, for additional information.
Misclassification of employees
The consequences of treating an employee as an independent contractor are as follows: if you classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker. See Internal Revenue Code Section 3509 for additional information.
Tax Topic 762 Basic Information: To determine whether a worker is an independent contractor or an employee, you must examine the relationship between the worker and the business. Consider all evidence of control and independence in this relationship. The facts that provide this evidence fall into three categories: Behavioral Control, Financial Control, and the Type of Relationship itself. Publication 1976, Section 530 Employment Tax Relief Requirements (PDF): Section 530 provides businesses with relief from Federal employment tax obligations if certain requirements are met. IRS Internal Training: Employee/Independent Contractor (PDF): This manual provides you with the tools to make correct determinations of worker classifications. It discusses facts that may indicate the existence of an independent contractor or an employer-employee relationship. This training manual is a guide, and is not legally binding. If you would like the IRS to make the determination of worker status, please file IRS Form SS-8. Form SS-8 (PDF): Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. Publication 15-A: The Employer’s Supplemental Tax Guide has detailed guidance including information for specific industries. Publication 15-B: The Employer’s Tax Guide to Fringe Benefits supplements Circular E (Pub. 15), Employer’s Tax Guide, and Publication 15-A, Employer’s Supplemental Tax Guide. It contains specialized and detailed information on the employment tax treatment of fringe benefits.
Adapted from the IRS Web site.