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Employee Versus Contractor: A Crucial Distinction for Every Organization

May 25, 2022

Employee or contractor? It’s a hot topic, especially during times of rapid workforce adjustments like those in recent years. Unfortunately, it’s not always easy to distinguish between the two. Getting the answer right is crucial, though. Worker misclassification is a serious offense with steep penalties, so companies that use contractors must classify these workers correctly.

Proper Classification Determines Tax Treatment

Determining whether a worker is an independent contractor or an employee for federal income and employment tax purposes is complex, and it has significant financial ramifications for workers and businesses.

If a worker is an employee, the company must withhold federal income and payroll taxes and pay the employer’s share of Federal Insurance Contributions Act (FICA) taxes on the wages, plus Federal Unemployment Tax Act (FUTA) tax. Often, the business must also provide the worker with fringe benefits it makes available to other employees. And there may be state tax obligations, as well.

If a worker is an independent contractor, the business simply sends the contractor a Form 1099-NEC for the year showing the gross amount paid (if the amount is $600 or more). The burden of payroll taxes shifts entirely into the worker’s domain, while the business can deduct the labor costs.

Distinction Can Be Unclear

There’s no clear, ironclad definition for “employee” that applies across the board. The IRS and courts have generally ruled that individuals are employees if the organization they work for has the right to control and direct them in the jobs they’re performing. Otherwise, the individuals are generally independent contractors, though other factors are considered.

Some employers that have misclassified workers as independent contractors may qualify for a relief provision that forgives employment tax liabilities. However, the provision doesn’t apply to certain types of technical services workers (such as engineers, designers, computer programmers, or systems analysis). This relief is also available only if an employer filed all federal returns consistent with its treatment of a worker as a contractor, and treated all similarly situated workers as contractors.

The employer must also have a “reasonable basis” for not treating the worker as an employee. For example, a reasonable basis exists if a significant segment of the employer’s industry traditionally treats similar workers as contractors.

IRS Can Advise, but Clarity Comes with Risk

In cases where the employer is unsure of the appropriate treatment, it might be best to use Form SS-8 to rule on whether a worker is an independent contractor or employee. Just keep in mind that the IRS has a history of classifying workers as employees rather than independent contractors.

Best practices also dictate that asking the IRS isn’t step one. Filing Form SS-8 may alert the IRS that your company has worker classification issues — and inadvertently trigger an employment tax audit — so consult a CPA first.

As labor shortages persist and businesses seek out new pools of talent, many business leaders have questions about how to classify their workforce. As you weigh these and other concerns regarding the growth of your business, consult your CRI advisor for insight and guidance.

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