Independent Contractor vs. Employee (IRS Advice)
Payroll taxes are one of the largest expenses for small and medium-sized businesses.
It is easy to get behind on these taxes. Once a business gets behind on payroll taxes, it can be very difficult to get caught up.
This is why misclassifying employees as independent contractors can be a very costly mistake.
The IRS has a whole audit team that is looking for taxpayers who make this mistake.
If they catch you and you misclassify your workers, you may find yourself with a sizeable tax debt that your business cannot afford to repay.
This article helps explain why workers are misclassified, why your workers may actually be contractors, and how to fend off an IRS payroll tax attack.
Is it better to be an Employee or an Independent Contractor for Tax Purposes?
There is no one correct answer to this question.
As explained below, there are numerous advantages and disadvantages for both the employer and the worker. This is true when viewed from the vantage point of the worker as the taxpayer and from the vantage point of the employer as the taxpayer.
This analysis involves more than just tax considerations. The answers to the questions below should help you evaluate these pros and cons.
What is an Independent Contractor? What is an Employee?
The easiest way to explain the difference between an independent contractor and an employee is to describe both, so you can compare and evaluate the differences.
A worker who is an employee will usually be entitled to various legal protections. Some of these protections vary from state to state and based on the size of the business and its industry. Others are standard, such as the protections found in the Fair Labor Standards Act (“FLSA”). These protections are enforced by the Department of Labor (“DOL”) and the corresponding state agencies.
At a minimum, these protections include the right to a minimum wage, hour laws, unemployment insurance coverage, and possibly certain benefits–such as health insurance, access to pension plans, paid leave and holidays, and other fringe benefits.
In addition, the employer may view the employee as more stable and reliable. Employers often offer training and advancement opportunities to employees based on this stability and the perceived permanency of the relationship.
These benefits can come with some strings. The employee has a duty of loyalty to their employer. This means that they cannot compete with the employer while employed, they have to dedicate their time and talents to the employer, and the employer does not have to share the profits of the employee’s efforts with the employee. The employee has no real opportunity for profit.
A worker who is an independent contractor has none of the benefits noted above, but also does not have the strings that come with them either. The independent contractor is on their own when it comes to health insurance and other benefits. The independent contractor may be expected to have other clients or customers they are to perform services for concurrently. Independent contractors are often on their own when it comes to training and advancement. The contractor may be viewed as a temporary worker, and not offered any advancement opportunities.
Who Pays More Taxes, Independent Contractor or Employee?
The answer to this question is, “it depends.” Let’s consider the taxes paid by employees and the taxes paid by independent contractors.
An employee pays income tax on their wages. They also pay employment taxes on their wages. Both taxes are withheld by the employer and remitted to the IRS.
Employee wages are taxed as ordinary income (as are payments made to contractors). This means that the wages are subject to higher ordinary income tax rates.
The employee is generally not able to deduct any expenses they incur for their work. This change was made to our tax code as part of the Tax Cuts & Jobs Act of 2017. Thus, the employee’s wages are not offset by any work-related tax deductions.
Compare this to independent contractors. The independent contractor does not have Federal income tax or payroll taxes withheld from their pay. Instead, they are obligated to remit estimated taxes to the IRS monthly, quarterly, or annually (depending on the amount of tax due).
Contractors are able to deduct all of their ordinary and necessary business expenses. Thus, contractors are able to reduce their business income by these business tax deductions. This can significantly reduce the contractors’ Federal income taxes.
Contractors do not pay payroll taxes. Instead, they pay self-employment taxes. Self-employment taxes are equivalent to payroll taxes for employees. The amount of self-employment taxes is twice that of what the employee pays in payroll taxes, but the contractor gets to deduct half of these taxes for income tax purposes. Because self-employment taxes are computed after reductions for business deductions and given the deduction for half of these taxes, contractors usually pay less than employees when it comes to payroll taxes.
The TCJA also provides another tax benefit for contractors. Contractors may be entitled to the Section 199(a) deduction. This deduction is 20 percent of the net earnings. This deduction can be significant. It can greatly reduce the contractors’ Federal income taxes.
If that is not complex enough, there are several situations where employment taxes are not due. For example, the crewman’s exemption allows some boat owners to avoid employment taxes.
This brings us to the answer to the question. In many cases, the contractor will pay less taxes than an employee.
How to File Taxes as an Independent Contractor?
An independent contractor pays income taxes by filing a Form 1040, Individual Income Tax Return, with the IRS each year. The business income and expense will be reported on Form 1040, Schedule C. Form 1040, Schedule SE, is used to compute the amount of self-employment tax due.
The independent contractor can also opt to form a business entity, such as an LLC, and elect to be taxed as a partnership, S corporation, or C corporation. There are several tax implications for this decision, but they are beyond the scope of this article.
How Does an Independent Contractor Pay Taxes?
The independent contractor pays their income taxes by making monthly, quarterly, or annual payments to the IRS. These estimated payments are pre-payments in that they are paying the tax that will be computed on the contractor’s tax return the following year.
If the contractor has made sufficient payments throughout the year, they will not owe any additional taxes when they file their income tax return. If they overpaid or underpaid, they will either get a refund or owe additional taxes at that time.
Is an Independent Contractor Self-Employed?
Yes, an independent contractor is self-employed. They are required to pay self-employment taxes on their earnings.
How Does the IRS Determine if a Person is an Independent Contractor? How Does the IRS Define an Employee?
There are rules that help dictate whether a worker is an independent contractor or an employee. Many of these rules can be found in our common law, Section 530 of the Revenue Act of 1978, and Revenue Ruling 87-41.
Rev. Rul. 87-41 20 factor test
Revenue Ruling 87-41 provides a number of factors that must be evaluated to determine whether a worker is an independent contractor or employee. These factors are often referred to as the 20 factor test.
The 20 factors are as follows:
- Instructions: If the person for whom the services are performed has the right to require compliance with instructions, this indicates employee status.
- Training: Worker training (e.g., by requiring attendance at training sessions)indicates that the person for whom services are performed wants the services performed in a particular manner (which indicates employee status).
- Integration: Integration of the worker’s services into the business operations of the person for whom services are performed is an indication of employee status.
- Services rendered personally: If the services are required to be performed personally, this is an indication that the person for whom services are performed is interested in the methods used to accomplish the work (which indicates employee status).
- Hiring, supervision, and paying assistants: If the person for whom services are performed hires, supervises or pays assistants, this generally indicates employee status. However, if the worker hires and supervises others under a contract pursuant to which the worker agrees to provide material and labor and is only responsible for the result, this indicates independent contractor status.
- Continuing relationship: A continuing relationship between the worker and the person for whom the services are performed indicates employee status.
- Set hours of work: The establishment of set hours for the worker indicates employee status.
- Full time required: If the worker must devote substantially full time to the business of the person for whom services are performed, this indicates employee status. An independent contractor is free to work when and for whom he or she chooses.
- Doing work on employer’s premises: If the work is performed on the premises of the person for whom the services are performed, this indicates employee status, especially if the work could be done elsewhere.
- Order or sequence test: If a worker must perform services in the order or sequence set by the person for whom services are performed, that shows the worker is not free to follow his or her own pattern of work, and indicates employee status.
- Oral or written reports: A requirement that the worker submit regular reports indicates employee status.
- Payment by the hour, week, or month: Payment by the hour, week, or month generally points to employment status; payment by the job or a commission indicates independent contractor status.
- Payment of business and/or traveling expenses. If the person for whom the services are performed pays expenses, this indicates employee status. An employer, to control expenses, generally retains the right to direct the worker.
- Furnishing tools and materials: The provision of significant tools and materials to the worker indicates employee status.
- Significant investment: Investment in facilities used by the worker indicates independent contractor status.
- Realization of profit or loss: A worker who can realize a profit or suffer a loss as a result of the services (in addition to profit or loss ordinarily realized by employees) is generally an independent contractor.
- Working for more than one firm at a time: If a worker performs more than de minimis services for multiple firms at the same time, that generally indicates independent contractor status.
- Making service available to the general public: If a worker makes his or her services available to the public on a regular and consistent basis, that indicates independent contractor status.
- Right to discharge: The right to discharge a worker is a factor indicating that the worker is an employee.
- Right to terminate: If a worker has the right to terminate the relationship with the person for whom services are performed at any time he or she wishes without incurring liability, that indicates employee status.
Common law analysis
The courts have applied their own factor analysis. These factors can also be used to evaluate whether a worker is an independent contractor or an employee. The courts have emphasized the degree of control exercised by the employer over all of the other factors. There are numerous court cases for these disputes that you can review to see how the court applies these factors.
Sec. 530 of the Revenue Act of 1978
In other cases, the contractor vs. employee dispute involves the statutory employee rules. These rules apply to employees who are closer to being contractors than employees, such as traveling salesmen. If these rules apply, from the employer’s perspective, the worker is paid like any other employee, but they are able to deduct their unreimbursed business expenses.
Section 530 of the Revenue Act of 1978 is a safe harbor provision that prevents the IRS from retroactively and prospectively reclassifying workers who were treated as non-employees (i.e., “independent contractors”) as employees and subjecting the business to Federal employment taxes, penalties, and interest for such misclassification, provided that the employer meets all the requirements of Section 530.
In order for an employer to qualify for Section 530 relief, the following three requirements must be met for each tax year for each class of workers:
- Reporting Consistency: The business must have filed all required Federal tax returns (including information returns) consistent with its treatment of each worker as not being employees.
- Substantive Consistency: The business (and any predecessor business) must have treated the workers, and any similar workers, as independent contractors. If the business treated similar workers as employees for the tax year under examination or in a prior tax year, this relief provision is not available.
- Reasonable Basis: The business must have had a reasonable basis for not treating the workers as employees, such as a court case or a ruling issued to the business from the IRS or an audit by the IRS in which the workers were not reclassified.
IRS Employee Classification Audits
The IRS employment tax group is a specialty tax group that is part of the Small Business/Self-Employed Division of the IRS. It is always on the lookout for workers who are classified as independent contractors.
This group sources its own audits (usually by obtaining state unemployment insurance tax records) and accepts referrals from IRS agents who are working income tax audits.
To help reduce this uncertainty employers are able to request a determination from the IRS as to whether a new hire qualifies to be treated as an independent contractor. The IRS issues the employer a determination letter that the employer can then rely on.
Absent such a request employers face the prospect of a disgruntled independent contractor either taking the position that they were an employee on their tax returns or the contractor asking the IRS to rule that they were an employee. In this case, business owners are put in the position of having to go back and prove that the employee was actually an independent contractor. This can be difficult to do without the cooperation of the independent contractor. Luckily, the courts have held that the employer is able to access the employee’s IRS records for this purpose.
This often results in the employer being held responsible for significant payroll tax liabilities. In some cases, the employer may qualify for the IRS Voluntary Classification Settlement Program (“VCSP”). This program allows the employer to reach an agreement with the IRS. The agreement requires the employer to admit that the independent contractor was an employee and the IRS agrees to only hold the employer liable for one year of payroll taxes for the employee.
Whose Assets are at Risk?
Once the tax is assessed, the IRS has its normal tools to collect the taxes (it also has the employment tax levy, as noted above). This includes levying on or seizing the business’ property.
There are questions as to whose property the IRS can levy or seize to pay employment taxes. For example, what if the business operates as a single-member LLC or disregarded entity? Does the IRS’s power reach the entity’s property or the owners?
In the past, the IRS disregarded the entity and looked to the owner’s assets. The rules changed for employment tax periods beginning on or after January 1, 2009. The IRS is now limited to business assets.
An experienced tax attorney can help you understand your tax obligations for your employees and help resolve your payroll tax problems.
Planning for Employment Tax Audits
An experienced tax attorney can also help you review and structure your employee and independent contractor relationships so that your business does not run into these types of payroll tax problems.
Employers often try to avoid payroll tax problems by executing written non-independent contractor agreements. For the most part, these agreements have proven to be inconsequential for tax purposes. This is especially true if the agreements do not reflect the true nature or economic realities of the business relationship.
These agreements should be used as a tool for structuring the business relationship, for highlighting the factors that support independent contractor status, and for downplaying the factors that support employee status. This is just the starting point. Additional documentation is usually needed.
There are other business structures that can also help.
Help With Worker Classification
We are tax attorneys in Houston, Texas and we help with payroll tax problems. This includes employment tax audits involving worker classification issues and helping clients plan for these disputes before the IRS shows up.
If you are under audit by the IRS for employment taxes or you have questions about worker classification, please call us at (713) 909-4906 for a free consultation.