Independent Contractor or Employee? The Distinction Matters

Sometimes, the IRS and employers clash over the classification of workers as independent contractors or employees. And no wonder: The stakes are high. If workers are employees, their employers are responsible for withholding payroll taxes, observing certain labor laws and providing fringe benefits. Employers that misclassify employees as independent contractors may become responsible for paying back taxes, interest and penalties if the IRS reclassifies them. So it's important to classify workers correctly the first time.

magnifying glass reviewing employee types

Avoiding Misclassification — and Penalties

There's no easy test for determining whether a worker is an employee or an independent contractor. But the ability of the worker to determine how the job is done, how you pay the individual and the existence of any employment contract all factor into the equation. In a nutshell, if you have little or no control over the way workers do the work, they generally are considered to be independent contractors.

But let's say you require workers to be in the office from nine to five and to use your equipment and supplies to complete assignments. You pay these workers every two weeks and provide them with health care benefits. The workers would generally be considered employees. But if you're unsure, you should discuss the issue with your tax advisor.

Section 530 Relief May Be Available

Fortunately, there may be another way to avoid trouble associated with worker misclassification: the Section 530 safe-harbor rule. This provision, which is from a largely forgotten 1978 law, may possibly be used if the IRS assesses back taxes and penalties on your company for misclassifying workers as independent contractors.

You must meet three requirements to obtain Section 530 relief:

  1. Reasonable basis. Your company needs a "reasonable basis" for treating workers as independent contractors, not employees. This basis might, for example, be established by a relevant court case, IRS ruling or prior audit.
  2. Employment status consistency. Your business must have consistently treated disputed workers — and any similarly situated workers — as independent contractors. There's no exception to this rule.
  3. Reporting consistency. You must have filed all federal tax returns consistent with your treatment of the workers as independent contractors. For instance, you must have provided them with Form 1099s, not W-2s, in the past.

Finally, if you aren't sure you're properly classifying workers, you can ask the IRS for a determination. But first check with your tax advisor before going this route because it may not be the best option. If you do file the form, the IRS will review your case and make a determination, generally within six months.

Withholding and Other Responsibilities

If your workers are, in fact, employees, your company must withhold federal income tax and the employee's share of Social Security and Medicare taxes. In addition, you need to pay the employer's share of the taxes and federal unemployment tax. You're also required to provide Form W-2s annually to all employees, as well as the IRS.

The overall dollar amount of federal payroll tax is adjusted each year. For 2022, the Social Security wage base is $147,000 and the tax rate is 6.2%. (The wage base is increasing to $160,200 in 2023.) As it has been for decades, the Medicare portion of the tax is 1.45% and applies to all wages paid to an employee.

So, for example, if you pay an employee $150,000 in 2022, the Social Security portion is $9,114 (6.2% of $147,000) and the Medicare portion is $2,175 (1.45% of $150,000). The total, $11,289, is the amount the employee and your organization must pay. (This is only a breakdown of federal tax liability. You may also be responsible for withholding certain state and local taxes.)

Finally, workers who are classified as employees generally are eligible to receive benefits such as health insurance and 401(k) plan participation. So the more fringe benefits you offer, the higher the cost when workers are deemed employees.

Help When There's No "Bright Line"

Because there's no "bright line" test for designating workers employees or independent contractors, it can be easy for employers to make mistakes. That's where Section 530 relief may come in. Contact us with questions about classifying workers and for help if the IRS claims your organization has violated the rules.

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