Let’s say you have a porch to build or a white paper to write, and you need to hire a contractor to build your porch or a freelance writer to write your white paper. You probably have a predetermined length of time in mind for the project and a predetermined amount you want to pay. In such a situation, you would probably classify the contractor or freelance writer as an independent contractor instead of a regular employee.
Deciding whether to classify a worker as an independent contractor or an employee has financial and tax implications for you.
The Internal Revenue Service clarifies the difference between the two.
“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,” according to the IRS website.
An employee fills out Form W-4. An independent contractor fills out Form W-9 and the employer fills out Form 1099.
Deciding whether a worker is an employee or an independent contractor is largely a question of who determines how the work gets done. If the answer is you, the employer, then you probably have an employee. You tell the employee where, when, and how to build the mousetrap. If the answer is the worker, then you probably have an independent contractor. The independent contractor builds the mousetrap to your specifications, but he can do it at 3 a.m. in his pajamas if he wants to.
The IRS offers “common law rules” to determine whether a worker is an employee or independent contractor. Employers must consider several determinants, which are explained on the IRS website, when deciding which way to classify. And they must consider those determinants carefully. Employers who misclassify workers as independent contractors can end up with substantial tax bills. Additionally, they can face penalties for failing to pay employment taxes and for failing to file required tax forms.
In April, the Employee Misclassification Prevention Act was introduced in the U.S. House and Senate. It would, according to the text of the bill, “amend the Fair Labor Standards Act of 1938 to require persons to keep records of non-employees who perform labor or services for remuneration and to provide a special penalty for persons who misclassify employees as non-employees, and for other purposes.”
The bill, known as H.R. 5107 in the House and S. 3254 in the Senate, was referred to committee in both bodies.
In September, the Fair Playing Field Act of 2010 was introduced in the House (H.R. 6128) and Senate (S. 3786). The text of the bill states that it would “amend the Internal Revenue Code of 1986 to permit the Secretary of the Treasury to issue prospective guidance clarifying the employment status of individuals for purposes of employment taxes and to prevent retroactive assessments with respect to such clarifications.”
That bill was referred to committee in both bodies as well.
Additionally, President Obama’s fiscal year 2011 budget set aside $25 million for the Department of Labor to address misclassification. The Department of Labor is also working with the Department of Treasury to address the issue.
For more information, visit the IRS website.