In the U.S., there are two types of worker categories as defined by the IRS: employee and independent contractor. The classification of the worker determines the employer's responsibilities for payroll liabilities, benefits, and quarterly and annual remuneration reporting. Identifying the classification between an employee and a contractor can be a gray area. Some factors that indicate a contractor relationship include the strong financial investment of the worker, working multiple jobs at once, and payment in a lump sum. Factors indicating the employee relationship include hourly pay, reimbursement of expenses, job training, and a required schedule.
In general, the degree of control and flexibility plays the largest role. According to the IRS, any individual who performs services for the employer is your employee if you can control what will be done and how it will be done. An individual is an independent contractor if the worker has the right to control how the work will be done. It is important to understand the difference in classifications because of the differences in tax treatments as detailed below.
Independent Contractor
Independent contractors are self-employed. They often have a significant investment in the job equipment when working for someone else. Independent contractors are likely to have unreimbursed expenses and are not covered under an employer-provided benefit plan. An example of an independent contractor is a worker in the lawn service industry. The worker has the flexibility to determine how the work is done and is required to provide the equipment to complete the job.
Employee
The IRS notes that an employee is generally subject to the companies’ instructions about when, where, and how to work. If a business provides the worker with job-related training, this indicates the business wants the job done in a certain way. This is evidence that the worker is an employee. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. An individual who is eligible for the company benefits is generally considered an employee. Employee benefits include items such as insurance, pension plans, paid vacation, sick days, and disability insurance.
Remote Worker
The number of individuals interested in the remote work environment is growing.1 An individual performing services for a company from a location other than an office owned by the company is an employee under the same control rules applicable to in-office workers. The remote worker is classified as an employee if the employer has control over what will be done and how it will be done.
Tax Considerations
The classifications are important due to the difference in taxation for each classification. For an employee, the employer is required to take action for a variety of payroll requirements. The employer will need to determine how much to withhold in federal income taxes using the employee’s Form W-4. In addition, the employer must withhold Social Security and Medicare taxes. Quarterly, it is required to file a Form 941 return and state unemployment taxes (SUTA) reporting. Annually, federal unemployment taxes (FUTA) reporting is required on Form 940 and completion of the annual Form W-2.
The employer is not required to withhold or make payroll tax payments for an independent contractor. The employer is required to issue the worker a Form 1099 with the total amount paid for services completed in the calendar year. The earnings on wages reported of Form 1099 are generally subject to a self-employment tax rate of 15.3%. The rate consists of two parts: 12.4% for Social Security and 2.9% for Medicare. This means the contractor is paying both the employer and employee portion of the required payroll taxes because the IRS views the individual as both the employer and employee. However, the contractor can claim a deduction on the employer-equivalent portion (6.2% for Social Security and 1.45% for Medicare) of their self-employment tax in calculating their adjusted gross income.
This is different from the employee classification in which the employer pays half the burden of half of the payroll liability.
Best Practices
The company should consider IRS guidance when gauging a worker's classification. The key is to review the entire relationship as a whole and consider the extent of the control and flexibility for the worker. After coming to a conclusion, the company should document the details used to make the decision.
If you have questions or need assistance, please reach out to an outsourced accounting professional at Forvis Mazars.
- 1“Work Migration: The Rise Of Remote Working And You,” forbes.com, January 30, 2024.