Fun Asia Show Recording-November 28, 2013

Independent Contractors – How to Avoid Tax Problems

 Tax Issue

There is a real incentive for small business owners to try to avoid payroll taxes and the administrative red tape that goes along with hiring workers as employees. Treating workers as independent contractors is tempting when one considers that there is no corresponding payroll tax return to file, no employer matching for FICA, no unemployment tax, and no workers’ compensation insurance to purchase. The only administrative cost of treating a worker as an independent contractor is the requirement to issue a 1099 to the worker at the end of the year.  However, the ability to treat a worker as an independent contractor is not contingent on the employer’s desire to keep it cheap and simple. There are consequences if the IRS decides the worker should have been treated as an employee.

Before a taxpayer knows how to treat payments made to workers for services, they must first know the business relationship that exists between their business and the person performing the services. A worker’s status (e.g., independent contractor or employee) determines what taxes are paid and who is responsible for reporting and paying those taxes.

Generally, a worker performing services for a business is classified as either a common-law employee or an independent contractor. Alternatively, statutory employees and statutory non-employees encompass a specific type of employment relationship briefly described on page 8-19. The distinction between an employee and independent contractor is very important because if misclassified, an employer may be liable for employment taxes, penalties, and interest on failure to withhold and remit certain required employment taxes.

Applicable Tax Law

There are four main classifications of workers, which determine what, if any, employment taxes must be paid by an employer.

  1. Employee. A worker treated as an employee will be issued Form W-2 for wages paid and the business hiring the worker is responsible for withholding income tax and FICA (Social Security and Medicare). The employer is also liable for FUTA (federal unemployment taxes. Also, the employee may be eligible for certain fringe benefits offered by the employer – such as health care.
  2. Independent contractor. A self-employed worker who is generally responsible for paying his or her own taxes through estimated tax payments. A business who hires an independent contractor will issue that person Form 1099-MISC for payments made.  In addition, the business is not generally responsible for withholding income tax for FICA. Form 1099-MISC must be issued to any one independent contractor, subcontractor, freelancer, etc., to whom the business made $600 or more in payments over the course of the tax year.
  3. Statutory employee. A worker who may qualify as an independent contractor under the common-law rules, but is treated as an employee under the Internal Revenue Code (IRC). Substantially all the services must be performed personally by the statutory employee for the employer in a continuing relationship, and the statutory employee cannot have a substantial investment in facilities used in connection with performing the services (other than transportation). Examples include
  • Agent-drivers or commission-drivers distributing meat products, vegetable products, fruit products, bakery products, beverages (other than milk), or laundry or dry-cleaning services.
  • Full-time life insurance salespeople.
  • Home workers making items according to specifications of the employer with materials or goods furnished to the worker by the employer, and the finished products are returned to the employer to sell.
  • Full-time traveling or city salespeople selling for one principal employer.
  1. Statutory non-employee. A worker who could be considered a common-law employee, but is treated as self-employed under the IRC. Examples include:
  • Direct seller. An individual who sells consumer products or consumer products for resale outside of a permanent retail store, or delivers or distributes newspapers or shopping news.
  • Licensed real estate agent

–  Both direct sellers and licensed real estate agents must have substantially all payments for services performed be directly related to sales, rather than hours worked, and services are performed under a written contract stating that they will not be treated as employees for federal tax purposes.

  • Companion sitter. An individual who provides personal attendance, companionship, or household care services to children or to individuals who are handicapped or elderly, and who is not an employee of a companion sitting placement service.

Factors used to determine independent contractor vs. common-law employee status. Except for specific types of statutory employees, the general rules for classifying workers as independent contractors or common-law employees hinge on who has the right to control the details of how services are to be performed. Under the common law, an employer-employee relationship exists when the principal has the right to control and direct the worker, not only as to the result to be accomplished, but also as to the details and means by which that result is accomplished.

Each situation is unique, and it is a facts and circumstances determination of worker status.

Factors used to make the determination on are grouped into three main categories.

  1. Behavioral factors. Factors that indicated a business has the right to control a worker’s behavior include:
    1. Instructions that the business gives to the worker. Employers generally control when and where work is to be done, what tools or equipment to use, what workers to hire or to assist with the work, where to purchase supplies and services, what work must be performed by a specified individual, and what order or sequence to follow.
    2. Training that the business gives to the worker. Employees may be trained to perform a service in a particular manner. Independent contractors generally use their own methods.
    3. Financial control. Factors that indicate a business has the right to control the business aspects of a worker’s job include:
      1. Extent of the worker’s unreimbursed business expenses. Independent contractors are more likely to incur expenses that are not reimbursed, such as fixed overhead costs that the worker incurs regardless of whether work is currently being performed.
      2. Extent of the worker’s investment. Independent contractors often have significant investment in facilities used to perform services for someone else, such as maintaining a separate office or other business location.
      3. Extent to which the worker makes his or her services available to the public. Independent contractors are generally free to offer their services to other businesses or consumers. They often advertise and maintain a visible business location.
      4. Method of payment for services performed. Employees generally are guaranteed a regular wage and work for an hourly fee or a salary. Independent contractors are generally paid a flat fee for a specific job. Exceptions apply to some professions, such as accountants and lawyers who charge hourly fees for their services.
      5. Extent to which the worker can make a profit. Independent contractors can make a profit or loss, whereas employees are simply paid a fixed wage.
      6. Type of relationship between the parties:
        1. Written contracts. Describe the relationship and intent between the worker and the business hiring the worker.
        2. Employee-type benefits provided to worker. Employers often provide fringe benefits to employees, such as health insurance, pensions, and vacation pay.
        3. Permanency of the relationship. Employer-employee relationships generally continue indefinitely.
        4. Extent services performed by the worker are a key aspect of the business hiring the worker. A worker who is key to the success of a business is more likely to be controlled by the business, which indicates employee status. For example, a law firm hires an attorney to provide legal services for clients. It is more likely that the law firm will present the attorney’s work as its own and would have the right to control or direct that work.

Safe harbor rules. A business can continue treating a worker as an independent contractor, even if the worker would otherwise be considered an employee if three requirements are met.

  1. Reasonable basis. A reasonable basis exists for not treating workers as employees if:
    1. The business relied on judicial precedent or published ruling, or
    2. A prior IRS employment audit of the business did not reclassify similarly treated workers as employees, or
    3. A significant segment of businesses in the same industry treat similar workers as independent contractors, or
    4. The business relied on any other reasonable basis, such as the advice of a lawyer or accountant familiar with the business.
    5. Substantive consistency. For all periods beginning after 1977, the business and any predecessor business must have treated the worker and any similar workers as independent contractors.
    6. Reporting consistency. All required federal tax returns, including Forms 1099-MISC, must have been filed consistent with the treatment of the worker as an independent contractor.

Note: Individuals providing technical services, such as engineers, designers, drafters, computer programmers, systems analysts, or other similar skilled workers, are classified as independent contractors or employees without regard to these safe harbor rules.

Employer liability. If an employer classifies an employee as an independent contractor and has no reasonable basis for doing so, the employer may be liable for employment taxes and the safe harbor rules will not apply. If an employer fails to treat workers as employees and does not qualify for the safe harbor relief, the employer is liable for each employee’s share of FICA tax and income tax withholding, in addition to the employer share of FICA and FUTA. The employer may obtain Form 4669, Statement of Payments Received, from the workers, attesting that income tax has been paid on the compensation.  All Forms 4669 for the tax year are submitted with Form 4670, Request for Relief from Payment of Income Tax Withholding, by the employer. The employer will then be assessed applicable penalties and interest.

If the employer is not able to obtain Form 4669 from the workers, the Code provides reduced rates for the employee share of FICA tax (20% of the employee’s share of FICA) and federal income tax withholding (1.5%). The employer’s share of FICA and FUTA tax are still payable in full, plus applicable penalties (12% – 35% of total tax bill) and interest on the underpaid amounts. If the employer failed to file Form 1099 due to reasonable cause and not willful neglect, the rates above apply. Otherwise, the employer’s liability is computed using 40% of the employee share of FICA and 3% for federal income tax withholding.


Tax Planning Strategies

It is essential for a taxpayer to determine the employment relationship upon the hiring of any worker providing services for the taxpayer’s business. If, after reviewing the three categories of evidence, it is still unclear whether a worker is an employee or an independent contractor, Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, can be filed with the IRS.  The form may be filed by wither the business or the worker, and IRS will review the facts and circumstances and officially determine the worker’s status.

Note: It can take at least six months to get a determination, but a business that continually hires the same types of workers to perform particular services may want to consider filing the Form SS-8.

A taxpayer should always request all new workers, upon being hired, to fill out Form W-9, Request for Taxpayer Identification Number and Certification. This form requests the worker to supply the taxpayer with their taxpayer identification number (SSN or ITIN, if applicable) and is used by the taxpayer in order to issue either Form W-2 (for employees) or Form 1099-MISC (for independent contractors), as applicable.

Any officer of a corporation providing services for his or her corporation in exchange for compensation is considered an employee of the corporation.

A director of a corporation in his or her capacity as such is not an employee of the corporation. Director fees are reported on Form 1099-MISC, box 7, and are subject to self-employment tax.

To avoid confusion as to independent contractor status, a business can seek to hire independent contractors who have incorporated their business rather than sole proprietors or partners. In this case, the corporation is the worker’s employer, not the taxpayer’s business.

Instead of hiring worker’s directly, many businesses lease them form an outside company, such as a temporary agency. Although it may cost the taxpayer more to lease workers than hire them directly (because a temporary agency will get a percentage), it will reduce occurrences of misclassifying workers.

A worker who receives a Form 1099-MISC instead of a W-2 has two options.

  1. Go along with the way the business has classified the worker, file Schedule C and SE, and pay SE tax on the earnings, or
  2. File Form SS-8. The IRS will then decide if the worker should have been treated as an employee, subject to income and FICA tax withholding.

If the IRS agrees that the worker really is an employee, the employer will be liable for employment taxes. However, if the IRS determines that the worker is really an independent contractor, the worker will be liable for paying SE tax.


Harold owns a restaurant and hires Jose, a gardener, to mow the lawn and weed the landscaping once a week. The contract states that Jose will arrive at the restaurant on Monday mornings, mow the lawn, pull weeds, and tend to the landscaping. In exchange, Harold agrees to pay Jose $50 for this service each week. Jose supplies his own lawnmower, weed eater, and hedge clippers. Jose decides what time he arrives and how long the job will take him. Harold does not supervise Jose in his tasks or dictate to him how they are to be done. Jose is an independent contractor. If Harold pays Jose a total of $600 or more for the year, he must issue a Form 1099-MISC to Jose (with an exact copy sent to the IRS along with Form 1096).


Possible Risks

  • If the taxpayer is a sole proprietor and provides services to their business, they will not pay themselves a wage or issue a Form 1099-MISC or W-2 at the end of the year. However, if the taxpayer organizes their business as an LLC and elects to be taxed as an S corporation, they must pay themselves a wage and the LLC issues a Form W-2 to the taxpayer at the end of the year.
  • An “employee” does not have to be a full-time worker. If there is an employer-employee relationship, it makes no difference how it is labeled. They substance of the relationship, not the label, governs the worker’s status. Therefore, it does not matter whether the individual is employed full-time or part-time.
  • A taxpayer must be able to prove payments made to independent contractors if claiming a deduction for wages paid. The best way in which to do this is to have issued Form 1099-MISC to each worker. Additionally, a taxpayer must provide Form 1099-MISC to any independent contractor, subcontractor, freelancers, etc., to whom they made more than $600 in payments over the course of the year.
  • For employment tax purposes, no distinction is made between classes or employees. Superintendents, managers, and other supervisory personnel are all employees; however, an officer who performs no services or only minor services, and neither receives nor is entitled to receive any pay, is not considered an employee. A director of a corporation is not an employee with respect to services performed as a director.
  • Whether a taxpayer is an employee or an independent contractor can affect if or where they can deduct expense. If a taxpayer is an employee, his expenses are deducted as itemized deductions – subject to the 2% AGI threshold. If a taxpayer is an independent contractor, his expenses are deducted on Schedule C.
  • If employees work at home for an employer, they are still working for the company. An employee of a company is someone who is subject to the company’s policies and procedures. The work that employees performs is dictated by the company, which also directs how and when that job is done.
  • If a taxpayer classifies an employee as an independent contractor and has no reasonable basis for doing so, they are liable for the employment taxes for that worker.
  • An employer is vicariously liable for the torts of their employee gardener who gets into a car accident when traveling between jobs (acting within the scope of his employment), and he is at least partially negligent for the accident, the employer is responsible to the same extent as the employee to any injured party. Generally, this is not the case with an independent contractor.
  • It is very important to be sure the worker relationship is truly as an independent contractor. The situation can occur where a business pays somebody as an independent contractor, whether or not the amount requires a 1099 MISC, and that individual decides at tax time (or after being caught by the IRS for nonpayment of taxes) that they really thought they were an employee the whole time and thought that the business was taking care of their taxes. In this case, the IRS will examine the work performed and, if it meets the definition of employee rather than independent contractor, the business will have to make federal tax withholding, FICA, and FUTA payments and there will be fines and penalties associated with the late payments.