Employee Versus Independent Contractor
The IRS pays close attention to whether you classify your workers as employees or independent contractors.1
You (as a business owner) do not pay payroll tax for independent contractors, but you do for employees.
The IRS knows that misclassifying employees as independent contractors will save you money, and thus they keep a careful eye out for business owners who abuse this practice (or make this mistake).
When you hire an employee, you have to pay more than just salary. You also pay payroll taxes (also known as employment taxes).
Payroll taxes include:
Social Security tax (which could cost you over $7,000 per employee),
Medicare tax (which costs you 1.45 percent of the employee’s salary), and
Federal Unemployment tax (which could cost you up to $420 per employee)
Additionally, when you have employees, you have to consider non-tax issues such as health care, retirement benefits, and state and federal law governing wages. These can also add expenses.
Independent contractors are self-employed. They control their work, set their own hours, and take on the risk of succeeding or failing in the business.
Employees, on the other hand, are agents of the employer. They follow their employer’s instructions, rely on regular pay rather than the profits of the business, and they perform work for one employer.
Of course, many workers do not fall entirely into either definition. They may have some attributes of independent contractors and some attributes of employees.
But you have to choose. You can only categorize your workers as one type or the other.
The IRS Test
The IRS considers three major factors to decide whether your workers are employees or independent contractors:2
Behavioral Control – Who controls how the work is done, which tools to use, where to purchase supplies, etc?
Financial Control – Does your worker have a significant investment in the work, and does he or she perform similar work for other businesses?
Relationship of the Parties – What language do you use in your contracts, and does your relationship continue beyond the completion of each work project?
The IRS does not rely on any single factor, and each decision depends on the facts of each case.
Penalties for Misclassification
If the IRS determines you are misclassifying workers (and therefore you are not paying payroll taxes), you can face penalties, back taxes and interest.3
Safe Harbor. If you have misclassified employees, you may be able to escape back taxes, penalties, and interest if you can prove to the IRS you had a “reasonable basis” for treating the workers as independent contractors.4
Voluntary Compliance Settlement Program (VCSP). Through the VCSP, you can pay a fee to reclassify your workers as employees – and avoid IRS audits, interest, and penalties.5
2 IRS Publication 1779, Independent Contractor or Employee, p. 2.
3 See IRC Sections 6651; 6656; 6721; 6722.
4 Section 530 of the Revenue Act of 1978, P.L. 95-600, as amended by Pub. L. 96167. Also this safe harbor is typically referred to as “Section 530 relief,” Section 530 is not part of the Internal Revenue Code.
5 Announcement 2012-45, 2012-51 I.R.B. 724 (12/17/2012).