Wednesday, January 9, 2008

Employee vs. Independent Contractor.

Recently, the IRS has indicated that it will be increasing its scrutiny of worker classification. That is, are businesses properly classifying workers as employees or as independent contractors. Misclassification can have a significant impact on both a business and its workers. Some of the aspects of worker classification are discussed below.

Businesses: Businesses that have employees must withhold income and Social Security/Medicare taxes from the employee’s income, contribute their own share of Social Security/Medicare taxes and issue Forms W-2. Employers must also pay FUTA (unemployment) taxes. On the other hand, if the business works only with independent contractors, there is no withholding and only a Form 1099 - MISC must be issued.

Workers: An individual that is an employee will receive a Form W-2 and report the information on his or her Form 1040, Individual Income Tax Return. If he or she is an independent contractor, however, the individual will receive a Form 1099 - MISC, will have to report the income on a Schedule C and must pay Self Employment Tax (Schedule SE). Additionally, because the business will not withhold tax on payments to an independent contractor, he or she must have had the foresight to save a portion of the income to pay taxes (often this is made easier by making estimated tax payments throughout the year).

Businesses: If a business is treating its employees as independent contractors, it will be failing to meet its federal tax obligations. That is, it will not be withholding income tax and Social Security/Medicare tax from the worker. Moreover, it will not be contributing its own share of the Social Security/Medicare tax liability. Assuming that the employee does not pay these amounts on his or her own when filing their tax return (a safe assumption) it is likely that the IRS will look to collect the tax from the business.

This problem can cascade down to the officers or owners of the business that were responsible for withholding the taxes and paying them over to the U.S. Treasury. These “responsible persons” can become personally liable for these employment taxes if the IRS assesses the Trust Fund Recovery Penalty against them.

Workers: A worker that believes that he or she is an employee will have a big surprise when they receive a Form 1099 MISC and file their tax return. If they have not made any estimated tax payments he or she will likely find themselves looking at a large tax liability. All is not lost, however, if that worker should have been classified by the business as an employee. In such a case, (for years 2007 and thereafter) that worker should file a Form 8819 that, essentially, reports the misclassification. (See Form 8819 here:

A discussion on the factors used to determine if a worker is an employee or independent contractor will be included in tomorrow’s post.

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