Classifying workers as independent contractors rather than employees can save an employer, on average, $3,710 annually in employment taxes. However, the IRS is clear on the difference between the two types of workers. As an employer, you must withhold income, Social Security and Medicare taxes and match employees’ Social Security tax withholding. Each year, you are required to issue W-2 forms to your employees. If your worker is an independent contractor, you have no obligation to withhold taxes, as the contractor is treated as any other vendor. You must issue a 1099 to all contractors you have paid $600 or more over the year.

Misclassifying employees has serious, negative financial consequences. Even if the mistake was not willful, and you honestly believed your workers were contractors and you filed 1099-MISC forms, you will be fined 1.5 percent of wages paid, plus 20 percent of the Social Security and Medicare tax you should have withheld from your employees’ pay. Those penalties are in addition to the full amount of Social Security and Medicare tax you, as an employer, are required to pay.

The issue of how workers are classified took on increased significance with the passage of the Affordable Care Act, which requires businesses with 50 or more full-time employees to offer affordable health insurance benefits or pay a Shared Responsibility fine. In a 2013 report, the IRS Inspector General recommends the IRS Commissioner step up efforts to identify businesses that mislabel their workers as independent contractors, increasing the likelihood that businesses that fail to comply with regulations will be getting a notice from the IRS.


Independent contractor or employee?

The IRS looks at three areas when making a determination on a worker’s classification

  • Behavior. The company controls where, when and how an employee works. Employees are trained by the employer and use tools and supplies provided by the company. Independent contractors run their own business. They provide their own tools and supplies and set their own hours.
  • Finance. The company controls the business aspect of the arrangement. Employee’s pay is set by the company and an employee cannot incur a loss. A worker who is not allowed to work for another business is most likely an employee. Independent contractors set their rates and may provide services for multiple businesses.
  • Relationship. If the worker is bound by a short-term contract, this may indicate an independent contractor. Benefits, such as paid time off and pensions that are part of a total compensation package indicate an employer to employee relationship.


If you are unsure how to classify your workers, you may file a Determination of Worker Status form with the IRS. Workers may also file this form. Note that it may take several months for the IRS to make a determination. If you have misclassified employees as independent contractors, you may get relief from some of the penalties if you voluntarily request a classification change under the Voluntary Classification Settlement Program.


This article was written by Gillian Burdett for Small Business Pulse


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