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Employee vs. Independent Contractor - Brief Review of the Rules

Classifying a worker as an employee versus an independent contractors is not always clear. This classification will impact the amount of tax that you pay as well as affect the additional costs a business may incur (most of these costs could be employee benefits rather than payroll taxes). The first step in determining how to treat payments that you make for services provided is to determine which category an individual falls into: statutory nonemployee, statutory employee, independent contractor or employee.  The key to making this decision is to consider all factors in the relationship between the service provider and the business, to consider the extent of the right to direct and control the worker, and lastly, to document the factors that are used in making the determination.

1.  The first step in determining the classification of a worker is to test for statutory nonemployee occupations. There are two categories of statutory nonemployees: direct sellers and licensed real estate agents. These individuals are treated as self-employed for all federal tax purposes if:

• Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked   
• Their services are performed under a written contract providing that they will not be treated as employees for federal tax purposes 

If your worker fits into the above categories then he or she is considered an independent contractor.  However, this is intended to be a rather narrow class of employees.

2.   The statutory employee classification is only relevant to a few classifications of employees. Even if workers are classified as independent contractors under the common law rules, they still may be treated as employees by statute for certain employment tax purposes. 

• Compensated corporate officers are considered statutory employees for Federal Income Tax Withholding statutes.
• Compensated corporate officers, agent drivers, full-time traveling sales persons, full-time life insurance sales persons and home workers are considered statutory employees for FICA tax statute purposes.
• For FUTA statute purposes all workers mentioned above for the FICA statute except full-time life insurance salespersons and home workers are statutory employees for FUTA purposes.

3.  Workers are usually considered employees when the employer controls what services they provide and how they provide them under common law rules. If the worker is indeed an employee, then the employer has the right to control the manner in which services are performed.  Common law rules, or factors to consider when classifying an employee are detailed in the following link. See the Common Law rules. Note the IRS has combined these into three broad classifications.

4.  A worker may be classified as an employee under the tests noted above but still be properly classified as an independent contractor for payroll tax purposes because of a provision in law known as Section 530 relief.  

To qualify for relief under Section 530 the employer must satisfy three conditions: Reasonable Basis, Substantive Consistency and Reporting Consistency. First you have to be able to confirm that you had a reasonable basis for treating your workers as contractors and not employees. To confirm this you can provide the IRS with a court case about Federal Taxes, a ruling issued by the IRS that you followed, or other "evidence” that the IRS had previously audited your business with respect to this issue and made no changes. You may also show that you relied upon reasoned advice of a business lawyer or accountant (just their statement on its own won’t work).   After a reasonable basis is proved, you must show that your business treated both the workers in question and any similar workers as independent contractors and have been consistent in such treatment over the years.  The last requirement that must be met is the reporting consistency; you must have filed all required federal tax returns consistent with your treatment of each worker as an independent contractor.

If after reviewing the steps above, it is still unclear whether a worker is an employee or independent contractor contact Kim Haumann at 312-980-3249 or your Blackman Kallick representative.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.