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2022 Tax Planning: Independent Contractor vs. Employee

November 9, 2022

Today businesses are making increasing use of outside workers. Unfortunately, this trend has caught the attention of the IRS. What the IRS is looking for are workers who are treated as independent contractors but who are essentially employees. If the IRS is successful in reclassifying workers, there is the potential of a substantial tax bill, such as the employer's back social security taxes and FUTA taxes, plus penalties and interest.

Classification of Employees and Independent Contractors

Any person who uses workers to perform services must determine whether each worker is an independent contractor or an employee. How a worker is classified depends on the facts and circumstances of each individual case. The proper classification is not always clear. But the distinction is critical for several federal tax reasons:

  • Whether the person paying the worker has employment tax responsibilities, withholding income taxes, paying Social Security and Medicare taxes, paying federal unemployment taxes, reporting employment taxes, etc.

  • The qualification for and tax treatment of certain fringe benefits.

  • Whether the person's business is a "large employer" under the shared responsibility health coverage rules and mandated to provide health coverage to employees; and

  • The right of the worker to deduct certain expenses related to providing services.

Classification for Employment Tax Purposes. If a worker is classified as an employee for employment tax purposes, the employer is responsible for:

  • Withholding federal income taxes.

  • Withholding the employee's share of Social Security and Medicare taxes.

  • Paying the employer's share of Social Security and Medicare taxes.

  • Paying federal unemployment taxes.

In contrast, businesses do not have any withholding or employment tax obligations for payments made to independent contractors. Independent contractors are responsible for paying their own income, Social Security and Medicare tax (self-employment taxes). Employee or Independent Contractor?

The degree of importance of any one factor varies based on the facts and circumstance of each case. The IRS has attempted to simplify the 20-factor test in favor of an examination of the facts based on the following three categories. 1. Behavioral control

  • Instructions: If you receive extensive instruction on how work is to be topics.

  • Training: If the business provides you with training about required procedures and methods.

2. Financial control

  • Significant Investment: If you have a significant investment in your work.

  • Expenses: If you are not reimbursed for some or all business expenses.

  • Opportunity for Profit or Loss: If you can realize a profit or incur a loss.

3. The relationship of the parties

  • Employee Benefits: If you are receiving befits, such as insurance, pension, paid time off.

  • Written Contracts: A written contract may show what both you and the business intend.

Caution If a business misclassifies an employee as an independent contractor for employment tax purposes, the business is liable for its share of the employment taxes, at least a portion of the employee's share of employment taxes, and penalties.

There is some good news in all this intricacy. First, taxes due may be reduced if the misclassification is unintentional. Second, in some cases, if you have always treated workers as independent contractors the IRS may let you go on doing so. You cannot take advantage of this safe harbor unless there was a reasonable basis for not classifying the individual as an employee in the first place and unless you have filed all returns required for nonemployees, such as Form 1099 information returns. Third, if you are unable to meet all the requirements but have filed returns, the IRS may let you settle for a fraction of the cost. Of course, there are times when the IRS is incorrect in its demands for reclassification and litigation, rather than quick settlement, may be the better course of action.

If you need help deciding whether to be an employee or an independent contractor, please contact us. We can collaborate with you to review existing payment arrangements, help you with future plans and advise you what, if any, action is necessary. We may even find workers are independent contractors who have been misclassified as employees.


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