One of the biggest tax challenges for companies is determining whether workers are employees or independent contractors. If a worker is an employee, then the employer is responsible for withholding income tax and the employee’s portion of Social Security and Medicare tax from amounts paid to the worker. The employer is also responsible for paying over to the IRS the employer’s portion of Social Security and Medicare tax, as well as paying the federal unemployment tax.
On the other hand, the business is not responsible for any payroll taxes for independent contractors. Many companies believe that they can choose whether to treat any given worker as an employee or independent contractor. However, there are laws that determine whether the worker is an employee or an independent contractor. So the first step is to properly classify the worker.
An employee is an individual who performs services for you, and who is subject to your control regarding what will be done and how it will be done. If the employer retains the right to direct and control the means and details of the work, then the worker is an employee. We call this the right to direct and control. It is the only definition, outside of court cases, you will find, and it can be found in Treasury Regulations Section 31.3121(d)-(1)(c), paragraphs (1) and (2). Remember this term, right to direct and control, because you will hear it throughout this presentation.
In contrast, an independent contractor is an individual who performs services for you, but you control only the result of the work, not the means and methods of accomplishing the result.
The information that we are covering is discussed in the Publication 1779, titled Independent Contractor or Employee, and is available on the IRS Web site.
Employee versus Independent Contractor
IRS Revenue Ruling 87-41 contains factors, commonly referred to as the twenty common law factors, that assess whether or not a business has the right to direct and control the actions of the worker.
Although this revenue ruling is still valid today, the IRS has grouped the more relevant ones into three main categories of evidence that show whether a worker is an employee or an independent contractor:
- One: behavioral control
- Two: financial control, and
- The third is the relationship of the parties.