Employers are required to classify the people who work for them per IRS rules and regulations. They can hire workers as independent contractors or as employees, but must classify them properly for payroll compliance to avoid penalties and fines. Employee classifications affect what employers pay in taxes, which tax documents to file and whether they must withhold taxes from employee paychecks. People who perform work for others are classified as employees or independent contractors depending on how their work is directed, who controls the financial aspects of the work being done and the type of relationship. Misclassifying employees as independent contractors can result in penalties and delinquent tax bills.
1099s (Independent Contractors) vs W2 Employees
According to IRS revenue ruling 87-41, an employee is defined as anyone who performs services for an employer wherein the employer controls what work is done and how it is done. This is generally called “the twenty factor test” in HR and payroll compliance.
Employees are paid wages from which the employer withholds and pays Social Security, Medicare and income taxes to the IRS and reports those wages and taxes on Form W-2. Independent contractors are paid to perform work but the business does not withhold or report income taxes for the workers, and reports it with a 1099 form when $600 or more has been paid out.
The three main factors for HR and payroll compliance in determining whether a worker is an independent contractor or an employee are behavioral control, financial control and relationship of the parties. Conditions such as receiving training, direct supervision and provided benefits indicate an employee/employer relationship. Situations where the worker incurs unreimbursed business expenses and realizes a profit or loss from the work indicate an independent contractor status.
W-4 and W-9 Forms
Employees must complete Form W-4 at the start of employment so that their employer can accurately withhold income taxes from paychecks. Form W-2 is issued to employees by employers at the end of the tax year to report wages earned and employee taxes withheld and paid. Employees use their W-2 to file income taxes.
Employers and businesses use Form W-9 to request the Taxpayer Identification Number (TIN) and backup withholding certification so that they can report the amount of income paid to an independent contractor. The IRS only requires employers to report when there is $600 or more in wages paid in a tax year, which then results in Form 1099. Independent contractors use Form 1099 to file their income tax returns.
Penalties for Misclassifications
Independent contractors don’t have the same benefits and protections as employees, including overtime, minimum wage, family and medical leave and unemployment insurance. The Social Security and Medicare, state unemployment insurance and worker compensation funds are shorted when employees are incorrectly classified as independent contractors. Therefore, misclassifying employees presents serious problems for affected employees, employers and the economy, which is why there are fines, penalties and back taxes imposed for doing so.
Pending legislation introduced by Senator Bob Casey (D-PA) November 12, 2013 called “Payroll Fraud Prevention Act of 2013” would make misclassification a federal labor offense with even more penalties. The bill also seeks to impose a notice requirement to obligate employers to inform both employees and independent contractors of their classification as “employee” or “non-employee.”
HR Solutions can assist in identifying the correct classification for your workers, including best practices and access to an HR Pro. PAYDAY Workforce Solutions can provide the forms necessary when hiring employees and independent contractors, and can produce forms W-2 and 1099 at year end. Contact us today for more information.