Classifying independent contractors

Ensure independent contractors are properly classified

Independent contractors can help ease staffing shortages and address other labor issues. But make sure you classify them appropriately.

Many businesses use independent contractors to help keep their costs down — especially during staff shortages and inflationary pressures. If you are among them, be careful that these workers are correctly classified for federal tax purposes. It can be an expensive mistake if the IRS reclassifies them as employees.

Why does classification matter?

Whether a worker is an independent contractor or an employee for federal income and employment tax purposes is complex. If a worker is an employee, your company must withhold federal income and payroll taxes and pay the employer’s share of Federal Insurance Contributions Act (FICA) taxes on the wages, plus Federal Unemployment Tax Act (FUTA) tax. A business may also provide the worker with fringe benefits if they are available to other employees. In addition, there may be state tax obligations.

On the other hand, if a worker is an independent contractor, these obligations do not apply. In that case, the business sends the contractor a Form 1099-NEC for the year showing the amount paid (if it is $600 or more).

What is the definition of an employee?

Who is an “employee?” Unfortunately, there is no uniform definition of the term.

The IRS and courts have generally ruled that individuals are employees if the organization they work for has the right to control and direct them in the jobs they are performing. Otherwise, the individuals are generally independent contractors. But other factors are also considered, including who provides tools and who pays expenses.

Some employers with misclassified workers as independent contractors may get some relief from employment tax liabilities under Section 530. This protection generally applies only if an employer meets specific requirements. For example, the employer must file all federal returns consistent with its treatment of a worker as a contractor and treat all similarly situated workers as contractors. Note: Section 530 does not apply to certain types of workers.

Should you ask the IRS for clarification?

Be aware that you can ask the IRS (on Form SS-8) to rule on whether a worker is an independent contractor or an employee. However, you should also be aware that the IRS has a history of classifying workers as employees rather than independent contractors.

Businesses should consult with us before filing Form SS-8 because it may alert the IRS that your business has worker classification issues and may unintentionally trigger an employment tax audit. It may be better to properly establish a relationship with workers to treat them as independent contractors so that your business complies with the tax rules.

Workers who want an official status determination can also file Form SS-8. Dissatisfied independent contractors may do so because they feel entitled to employee benefits and want to eliminate their self-employment tax liabilities. If a worker files Form SS-8, the IRS will notify the business with a letter. It identifies the worker and includes a blank Form SS-8. The business is asked to complete and return the form to the IRS, which will render a classification decision.

In summary

It can be challenging to classify independent contractors. Failing to do so correctly can open your organization up to potential issues with the IRS.

If you have questions about your employee classifications, contact Cindy McSwain using the information below.

Cindy McSwain

Senior Vice President
Outsourcing Services

Cindy McSwain leads AGH’s outsourcing services group. Her team provides payroll, accounting, funds disbursement, controller, and other financial outsourcing services to numerous clients throughout the U.S. Prior to joining the outsourcing group, Cindy served AGH’s audit clients for 10 years, working with a wide range of middle-market, closely held and family-owned organizations.

Her current clients cross many industry sectors, including manufacturing and distribution, restaurants, retailers, medical and not-for-profit. She has participated in numerous SEC filings and public registrations and has experience in mergers and acquisitions. Cindy is a certified public accountant and a member of both the American Institute of Certified Public Accountants and the Kansas Society of Certified Public Accountants.

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