IRS rules regarding independent contractors

An employer must generally withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. An employer does not generally have to withhold or pay any taxes on payments to independent contractors.

Common-law rules

To determine whether an individual is an employee or an independent contractor under the common law, the relationship of the worker and the business must be examined. All evidence of control and independence must be considered. In any employee-independent contractor determination, all information that provides evidence of the degree of control and the degree of 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 as shown below.

1. Behavioral control.

Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of:

• Instructions the business gives the worker. An employee is generally subject to the business’s instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work:

— when and where to do the work;

— what tools or equipment to use;

— what workers to hire or to assist with the work;

— where to purchase supplies and services;

— what work must be performed by a specified individual;

— what order or sequence to follow.

The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction.

The key consideration is whether the business has retained the right to control the details of a worker’s performance or instead has given up that right.

• An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.

2. Financial control.

Facts that show whether the business has a right to control the business aspects of the worker’s job include:

• The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services they perform for their business.

• The extent of the worker’s investment. An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.

• The extent to which the worker makes services available to the relevant market. An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.

• How the business pays the worker. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.

• The extent to which the worker can realize a profit or loss. An independent contractor can make a profit or loss.

3. Relationship type.

Facts that show the parties’ type of relationship include:

• Written contracts describing the relationship the parties intended to create.

• Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay.

• The permanency of the relationship. If you engage a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that your intent was to create an employer-employee relationship.

• The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of your regular business activity, it is more likely that you will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.

IRS help is available

If you want the IRS to determine whether a worker is an employee, file Form SS-8, Determin ation of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS.

Industry examples

The following examples from the IRS may help you properly classify your workers.

1. Computer industry

Example: Steve Smith, a computer programmer, is laid off when Megabyte Inc. downsizes. Megabyte agrees to pay Steve a flat amount to complete a one-time project to create a certain product.

It is not clear how long it will take to complete the project, and Steve is not guaranteed any minimum payment for the hours spent on the program. Megabyte provides Steve with no instructions beyond the specifications for the product itself. Steve and Megabyte have a written contract, which provides that Steve is considered to be an independent contractor, is required to pay federal and state taxes, and receives no benefits from Megabyte.

Megabyte will file a Form 1099-MISC. Steve does the work on a new high-end computer which cost him $7,000. Steve works at home and is not expected or allowed to attend meetings of the software development group. Steve is an independent contractor.

2. Attorney

Example: Donna Yuma is a sole practitioner who rents office space and pays for the following items: telephone, computer, on-line legal research linkup, fax machine, and photocopier. Donna buys office supplies and pays bar dues and membership dues for three other professional organizations. Donna has a part-time receptionist who also does the bookkeeping. She pays the receptionist, withholds and pays federal and state employment taxes, and files a Form W-2 each year.

For the past two years, Donna has had only three clients, corporations with which there have been longstanding relationships. Donna charges the corporations an hourly rate for her services, sending monthly bills detailing the work performed for the prior month. The bills include charges for long distance calls, on-line research time, fax charges, photocopies, postage, and travel, costs for which the corporations have agreed to reimburse her. Donna is an independent contractor.

3. Taxicab driver

Example: Tom Spruce rents a cab from Taft Cab Co. for $150 per day. He pays the costs of maintaining and operating the cab. Tom Spruce keeps all fares he receives from customers. Although he receives the benefit of Taft’s two-way radio communication equipment, dispatcher, and advertising, these items benefit both Taft and Tom Spruce. Tom Spruce is an independent contractor.

4. Salesperson

To determine whether salespeople are employees under the usual common-law rules, you must evaluate each individual case. If a salesperson who works for you does not meet the tests for a common-law employee, discussed earlier, you do not have to withhold income tax from his or her pay.

However, even if a salesperson is not an employee under the usual common-law rules, his or her pay may still be subject to social security, Medicare, and FUTA taxes. To determine whether a salesperson is an employee for social security, Medicare, and FUTA tax purposes, the salesperson must meet all eight elements of a statutory employee test. A salesperson is an employee for social security, Medicare, and FUTA tax purposes if he or she:

• works full-time for one person or company except, possibly, for sideline sales activities on behalf of some other person;

• sells on behalf of, and turns his or her orders over to, the person or company for which he or she works;

• sells to wholesalers, retailers, contractors, or operators of hotels, restaurants, or similar establishments;

• sells merchandise for resale, or supplies for use in the customer’s business;

• agrees to do substantially all of this work personally;

• has no substantial investment in the facilities used to do the work, other than in facilities for transportation;

• maintains a continuing relationship with the person or company for which he or she works;

• is not an employee under common-law rules.

Source: IInternal Revenue Service. Employer’s Supplemental Tax Guide. IRS Publications 15-A. Washington, DC; January 2000.