Using independent contractors is a smart way to help manage costs, especially during times of staffing shortages and inflation. If your business goes this route, it’s essential to ensure these workers are properly classified for federal tax purposes. Misclassifying employees as independent contractors can come with a hefty price tag, leading to audits, back taxes, penalties and even lawsuits if the IRS steps in and reclassifies them.

Worker Classification: Employee vs. Independent Contractor

Tax law requirements for businesses differ for employees and independent contractors, and determining the correct classification for federal income and employment tax purposes isn’t always straightforward. If a worker is classified as an employee, your business must:

• Withhold federal income and payroll taxes.
• Pay the employer’s share of FICA taxes.
• Pay federal unemployment (FUTA) tax.
• Potentially offer fringe benefits available to other employees.
• Comply with additional state tax requirements.

In contrast, if a worker qualifies as an independent contractor, these obligations generally don’t apply. Instead, the business simply issues Form 1099-NEC at year-end (for payments of $600 or more). Independent contractors are more likely to have more than one client, use their own tools, invoice customers and receive payment under contract terms, and have the potential to earn profits as well as suffer losses on jobs.

Employees, Defined

Unfortunately, there’s no single standard for what defines an “employee.” Generally, the IRS and courts look at the degree of control an organization has over a worker. If the business has the right to direct and control how the work is done, the individual is more likely to be an employee. Employees generally have tools and equipment provided to them and don’t incur unreimbursed business expenses.

Treating similar workers consistently and filing all related tax documents accordingly also matters, as this may qualify a business that misclassifies workers for relief under Section 530 of the tax code. But keep in mind, this relief doesn’t apply to all types of workers.

Requesting an IRS Determination of Worker Status: Proceed With Caution

Businesses can file Form SS-8 to request an IRS determination on a worker’s status. However, this move can backfire. The IRS often leans toward classifying workers as employees and submitting this form may draw attention to broader classification issues—potentially triggering an employment tax audit.

In many cases, it’s wiser to consult with a CPA to help ensure your contractor relationships are properly structured from the outset, minimizing risk and ensuring compliance. For example, you might:

• Use written contracts that clearly define the nature of employee relationships.
• Maintain documentation that supports the classifications.
• Apply consistent treatment to similar workers.
• And more.

When a Worker Questions Classification

Workers themselves can also submit Form SS-8 if they believe they’re misclassified—often in pursuit of employee benefits or to reduce self-employment tax. If this happens, the IRS will contact your business to complete Form SS-8 and then evaluate the situation and issue a classification decision.

Avoid Costly Mistakes

Worker classification is a nuanced area of tax law. If you have questions or need guidance, our pros are here to help you accurately classify your workforce to avoid costly missteps.