Independent Contractor vs. Employee

December 24th, 2010 BY Claire Moore

It is critical that you, the business owner, correctly determine whether the individuals providing services are employees or independent contractors. Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors.

The following is a brief and general discussion of this subject. If you need help evaluating your situation or that of a client then seek assistance from the IRS for a final ruling on the matter.

Facts that determine the status of a worker come down to Control. How much control does the business exercise over a worker and what kind of control will determine the status.

Evidence of the degree of control and independence fall into three categories:

Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job? If answers to the following questions is “Yes” then the worker is likely an employee.

1. Is the worker told when and where to do the work?
2. Is the worker told what tools and equipment to use?
3. Is the worker told who will assist in the work?
4. Is the worker instructed on the purchase of supplies and services?
5. Is each worker told what tasks must be performed?
6. Is the worker instructed on the sequence of when tasks are to be done?
7. Does the company evaluate how the work is performed and not just the end result?
8. Does the company provide training on how to do the job?

Even if the business does not provide any instructions regarding the work to be done, if the business retains the right to control the details of the worker’s performance then it can be assumed that the business is the employer and the worker is the employee and is not independent.

Financial: Are the business aspects of the worker’s job controlled by the payer? If the answers to the following questions is “Yes” then the worker is likely an independent contractor.

1. Does the worker have a significant investment in his own tools.
2. Does the worker incur expenses that are unreimbursed?
3. Is the worker free to seek out other business opportunities?
4. Is the worker paid by the job?

Type of Relationship: Will the relationship continue and is the work performed a key aspect of the business?

1. Is there a contract for services? The existence of a contract in and of itself doesn’t determine whether a worker is independent.
2. Does the worker get benefits such as insurance, pension and paid vacation? Again, the presence or absence of benefits does not mean that a worker is independent.
3. How permanent is the relationship? If a worker is hired with the expectations that the relationship will continue indefinitely, rather than for a specific period then that worker looks more like an employee than an independent contractor.
4. Does the worker provide services that are a key aspect of the business? If so, then it is likely that the business exercises significant control over how the services are performed and therefore the worker is likely an employee. For instance, if a bookkeeper hires another bookkeeper, it is likely that it will present the bookkeeper’s work as its own and then there is likely to be an employer-employee relationship.

Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.

The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.
You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed.

If an employer-employee relationship exists (regardless of what the relationship is called), you are not an independent contractor and your earnings are generally not subject to SE tax. If you’re not sure whether your wages are subject to SE tax, then consult with the IRS.

Forms and associated taxes for independent contractors

Form W-9

If you’ve made the determination that the person you’re paying is an independent contractor, the first step is to have the contractor complete Form W-9, Request for Taxpayer Identification Number and Certification. This form can be used to request the correct name and Taxpayer Identification Number, or TIN, of the worker. A TIN may be either a Social Security Number (SSN), or an Employer Identification Number (EIN). The W-9 should be kept in your files for four years for future reference in case of any questions from the worker or the IRS.

Form 1099-MISC

Form 1099-MISC is most commonly used by payers to report payments made in the course of a trade or business to others for services. If you paid someone who is not your employee, such as a subcontractor, attorney or accountant $600 or more for services provided during the year, a Form 1099-MISC needs to be completed. A copy of the 1099-MISC must be provided to the independent contractor by January 31of the year following payment. You must also send a copy of this form to the IRS by February 28 (although the form does not have to be sent to the IRS until March 31 if the business files the 1099s electronically, using the FIRE system).

Also note that independent contractors may have their own employees or may hire other independent contractors (subcontractors). In either case, they should be aware of their tax responsibilities, including filing and reporting requirements, for these workers.

Forms and associated taxes for employees

• Form 941, Employer’s Quarterly Federal Tax Return is used to report the withholding of Federal income tax, Social Security, and Medicare.
• Form 943, Employer’s Annual Federal Tax Return for Agriculture Employees
• Note: Employers who have an employment tax liability of $1,000 or less for the year may file Form 944, Employer’s Annual Federal Tax Return, instead of Form 941, Employer’s Quarterly Federal Tax Return. Eligible taxpayers will be notified by mail.

Report FUTA taxes on Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return
At the end of the year, the employer must complete Form W-2, Wage and Tax Statement to report wages, tips and other compensation paid to an employee. A copy of this form must be given to the employee by January 31st after the end of the year. You must also send a copy of the W-2 to the Social Security Administration (SSA). Employers can prepare and file up to 20 W-2s at a time at the Social Security Administration’s Web site. Using SSA’s online W-2 filing, employers can also print out all the necessary copies of the W-2 for their employees, state taxing agencies, etc.

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Self-Employment Tax

Self-employment tax (SE tax) is a social security and Medicare tax primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most wage earners.
You figure SE tax yourself using Schedule SE (Form 1040). Social security and Medicare taxes of most wage earners are figured by their employers. Also you can deduct half of your SE tax in figuring your adjusted gross income. Wage earners cannot deduct social security and Medicare taxes.

SE tax rate

The self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
Maximum earnings subject to SE tax. Only the first $102,000 of your combined wages, tips, and net earnings in 2008 is subject to any combination of the 12.4% social security part of SE tax, social security tax, or railroad retirement (tier 1) tax.

All your combined wages, tips, and net earnings are subject to any combination of the 2.9% Medicare part of SE tax, social security tax, or railroad retirement (tier 1) tax.
Self-employment tax deduction. You can deduct half of your SE tax in figuring your adjusted gross income. This deduction only affects your income tax. It does not affect either your net earnings from self-employment or your SE tax.

How to Pay Self-Employment Tax

To pay SE tax, you must have a social security number (SSN) or an individual taxpayer identification number (ITIN). This section explains how to:
• Obtain an SSN or ITIN
• Pay your SE tax using estimated tax.
Obtaining a Social Security Number. If you never had an SSN, apply for one using Form SS-5, Application for a Social Security Card. You can get this form at any Social Security office or by calling (800) 772-1213.

Download the form from the Social Security Online Web site.

Obtaining an Individual Taxpayer Identification Number. The IRS will issue you an ITIN if you are a nonresident or resident alien and you do not have and are not eligible to get an SSN.To apply for an ITIN , file Form W-7, Application for IRS Individual Taxpayer Identification Number.

Estimated Taxes

Federal income tax is a pay-as-you-go tax. You must pay the tax as you earn or receive income during the year. You generally have to make estimated tax payments if you expect to owe tax, including SE tax, of $1,000 or more when you file your return. There are two ways to pay as you go: withholding and estimated taxes. If you are a self-employed individual and do not have income tax withheld, you must make estimated tax payments.

Who Must Pay Self-Employment Tax?

You must pay SE tax and file Schedule SE (Form 1040) if either of the following applies.
• Your net earnings from self-employment (excluding church employee income ) were $400 or more.
• You had church employee income of $108.28 or more.
Your net earnings from self-employment are based on your earnings subject to SE tax. Most earnings from self-employment are subject to SE tax.

Note: The SE tax rules apply no matter how old you are and even if you are already receiving social Security or Medicare.

How To Figure Estimated Tax

To figure your estimated tax, you must figure your expected adjusted gross income, taxable income, taxes, deductions, and credits for the year.

When figuring your estimated tax, it may be helpful to use your income, deductions, and credits from last year’s tax return as a starting point. You can use the worksheet in Form 1040-ES to figure your estimated tax. If you estimated your earnings too high, simply complete another Form 1040-ES worksheet to refigure your estimated tax for the next quarter. If you estimated your earnings too low, again complete another Form 1040-ES worksheet to recalculate your estimated taxes for the next quarter. You want to estimate your income as close as you can to avoid penalties.

You must make adjustments both for changes in your own situation and for recent changes in the tax law.

When To Pay Estimated Taxes

For estimated tax purposes, the year is divided into four payment periods. Each period has a specific payment due date. If you do not pay enough tax by the due date of each of the payment periods, you may be charged a penalty even if you are due a refund when you file your income tax return. The following due dates apply to individuals (who are on a calendar year).

Dates would be different for a corporation. There is no allowance made here for weekends and holidays falling on a due date.
For the period: Jan. 1 – March 31 pay your estimated tax by April 15
For the period: April 1 – May 31 pay your estimated tax by June 15
For the period: June 1 – August 31 pay your estimated tax by September 15
For the period: Sept. 1 – Dec. 31 pay your estimated tax by January 15 of next year

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