Employee vs. Independent Contractor
W-2 vs 1099
If you misclassify a worker as an independent contractor and fail to withhold income taxes, you can be assessed with penalties of 1.5% of wages for federal income tax not withheld and 20% of the worker's share of FICA taxes not withheld. Additionally, you may be assessed with penalties of 3% for federal income tax not withheld and 40% of the worker's share of FICA if you failed to file a Form 1099.
The Internal Revenue Service (IRS) has used a common law 20-factor test to determine whether a worker is an independent contractor. However, recent changes in the tax law have made it easier for an employer to fend off the IRS challenge that someone treated as an independent contractor is an employee. For audits beginning in 1997, Section 530 of the Internal Revenue Code (IRC) now provides an exclusion that an individual will not be treated as an employee provided the employer:• Did not treat the worker as an employee for any period,• Did not treat any other worker holding a similar position as an employee,• Filed Form 1099 in a timely fashion for each worker, and• Has a reasonable basis for not treating the worker as an employee. The employer can argue it has a reasonable basis for independent contractor treatment based on three safe harbors: (1) a judicial precedent; (2) failure of the IRS to challenge the independent contractor classification on prior audits, and (3) industry practice to treat such workers as independent contractors.
A recent IRS summary is designed to clarify the relief that is now available under IRC Section 530. As amended, it states that the reasonable basis standard may also be met when a business owner relied on a business attorney or accountant who knew the facts about the business, when classifying the worker as an independent contractor.
The burden of proof in applying the Section 530 safe harbors has also been eased for taxpayers. First, the taxpayer must establish a prima facie case that it was reasonable not to treat the worker as an employee. Then, assuming the taxpayer fully cooperated with the IRS in providing relevant information about the treatment of the worker, and one of the three safe harbors exists, the burden of proof shifts to the IRS to show that the worker was not an independent contractor. In short, business owners who wish to treat workers as independent contractors should:• Treat similarly situated workers identically.• Determine that it is industry practice to treat such workers as independent contractors.• Issue Form 1099 to their independent contractors regularly.• Assess whether there is a judicial or administrative precedent for the treatment. In addition, to make certain that the treatment is proper, they can perform a common law analysis based on the IRS 20-factor test for determining the relationship between the worker and the business owner and who controls the work being performed. Finally, have the independent contractor sign contracts annually specifying the length of the relationship and indicating that the independent contractor is responsible for payment of income and payroll taxes.
If you misclassify a worker as an independent contractor and fail to withhold income taxes, you can be assessed with penalties of 1.5% of wages for federal income tax not withheld and 20% of the worker's share of FICA taxes not withheld. Additionally, you may be assessed with penalties of 3% for federal income tax not withheld and 40% of the worker's share of FICA if you failed to file a Form 1099.
The Internal Revenue Service (IRS) has used a common law 20-factor test to determine whether a worker is an independent contractor. However, recent changes in the tax law have made it easier for an employer to fend off the IRS challenge that someone treated as an independent contractor is an employee. For audits beginning in 1997, Section 530 of the Internal Revenue Code (IRC) now provides an exclusion that an individual will not be treated as an employee provided the employer:• Did not treat the worker as an employee for any period,• Did not treat any other worker holding a similar position as an employee,• Filed Form 1099 in a timely fashion for each worker, and• Has a reasonable basis for not treating the worker as an employee. The employer can argue it has a reasonable basis for independent contractor treatment based on three safe harbors: (1) a judicial precedent; (2) failure of the IRS to challenge the independent contractor classification on prior audits, and (3) industry practice to treat such workers as independent contractors.
A recent IRS summary is designed to clarify the relief that is now available under IRC Section 530. As amended, it states that the reasonable basis standard may also be met when a business owner relied on a business attorney or accountant who knew the facts about the business, when classifying the worker as an independent contractor.
The burden of proof in applying the Section 530 safe harbors has also been eased for taxpayers. First, the taxpayer must establish a prima facie case that it was reasonable not to treat the worker as an employee. Then, assuming the taxpayer fully cooperated with the IRS in providing relevant information about the treatment of the worker, and one of the three safe harbors exists, the burden of proof shifts to the IRS to show that the worker was not an independent contractor. In short, business owners who wish to treat workers as independent contractors should:• Treat similarly situated workers identically.• Determine that it is industry practice to treat such workers as independent contractors.• Issue Form 1099 to their independent contractors regularly.• Assess whether there is a judicial or administrative precedent for the treatment. In addition, to make certain that the treatment is proper, they can perform a common law analysis based on the IRS 20-factor test for determining the relationship between the worker and the business owner and who controls the work being performed. Finally, have the independent contractor sign contracts annually specifying the length of the relationship and indicating that the independent contractor is responsible for payment of income and payroll taxes.
There are other tax-cutting strategies in addition to those mentioned here. If you would like assistance in selecting tax-saving strategies that make the most sense in your situation, contact us today!