Classifying a worker as an independent contractor instead of an employee might seem like a way to simplify things, but getting it wrong is a costly mistake. The IRS and state agencies have strict rules, and misclassification can lead to severe penalties.
Table of Contents
- Why Does It Matter?
- How Does the IRS Decide?
- The Cost of Getting It Wrong
Why Does It Matter?
The classification determines how you pay taxes and what benefits you must provide.
- Employees: You withhold income taxes, pay Social Security/Medicare taxes (half of FICA), and pay unemployment taxes. You may also provide benefits like health insurance and workers’ compensation.
- Independent Contractors: You do not withhold taxes. They are responsible for paying their own self-employment tax. You provide a Form 1099-NEC at year-end if you pay them $600 or more.
How Does the IRS Decide?
The IRS uses a “right to control” test, focusing on three categories:
- Behavioral Control: Do you control what the worker does and how they do it? If you provide training and set specific hours, they look like an employee.
- Financial Control: Do you control the business aspects of the worker’s job? This includes how they are paid, whether they can work for others, and if they have their own tools and expenses.
- Relationship of the Parties: Is there a written contract? Do you provide benefits? Is the relationship permanent? A long-term, integral relationship points to an employee.
The Cost of Getting It Wrong
If you misclassify an employee as a contractor, you could be held liable for back taxes, interest, and penalties for all the taxes you failed to withhold and pay. This can amount to a devastating financial blow.
When in doubt, it’s safer to classify as an employee.
Get Classification Right
Need help? Payroll On The Money can guide you through worker classification to keep you compliant.