If you are managing a business, cost savings are a top priority. When it comes to cost savings, labor expenses is probably at the top of the list. With ‘labor expenses’ comes the decision of whether to hire people as internal employees (W2 employees) or Contract employees (AKA 1099 employees). While there are many advantages in hiring as internal employees, the “burden” is high. The burden typically includes the employer payroll tax, medical benefits and other standard company benefits, and other HR related hidden costs. So, there are many incentives to keeping people as 1099-employees because they are paid like any other service vendor and there is no “burden”.

However, IRS (and almost all States) regulate this option closely. Basically, you cannot just decide on one of the two, without looking into classification parameters.

The Internal Revenue Service wants businesses to correctly apply the rules of classification in terms of an employee or an independent contractor. For federal employment tax purposes, a business must examine the relationship between it and the worker. This classification is important because it determines if an employer must withhold income taxes and pay Social Security, Medicare taxes and unemployment tax on wages paid to an employee. Businesses normally do not have to withhold or pay any taxes on payments to independent contractors. The earnings of a person working as an independent contractor are subject to self-employment tax and it is managed by the contractor himself/herself with the personal tax filing.

The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done. Small businesses should consider all evidence of the degree of control and independence in the employer/worker relationship. Whether a worker is an independent contractor or employee depends on the facts in each situation.

How to Decide?

IRS expects business to consider the following three categories – Behavioral Control, Financial Control and Relationship of the Parties.

Behavioral Control:  A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. Behavioral control categories are:

• Type of instructions given, such as when and where to work, what tools to use or where to purchase supplies and services. Receiving the types of instructions in these examples may indicate a worker is an employee.
• Degree of instruction, more detailed instructions may indicate that the worker is an employee.  Less detailed instructions reflect less control, indicating that the worker is more likely an independent contractor.
• Evaluation systems to measure the details of how the work is done points to an employee. Evaluation systems measuring just the end result point to either an independent contractor or an employee.
• Training a worker on how to do the job — or periodic or on-going training about procedures and methods — is strong evidence that the worker is an employee. Independent contractors ordinarily use their own methods.

Financial Control: Does the business have a right to direct or control the financial and business aspects of the worker’s job? Consider:

• Significant investment in the equipment the worker uses in working for someone else.
• Unreimbursed expenses, independent contractors are more likely to incur unreimbursed expenses than employees.
• Opportunity for profit or loss is often an indicator of an independent contractor.
• Services available to the market. Independent contractors are generally free to seek out business opportunities.
• Method of payment. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other periods of time even when supplemented by a commission. However, independent contractors are most often paid for the job by a flat fee.

Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. This includes:

• Written contracts which describe the relationship the parties intend to create. Although a contract stating the worker is an employee or an independent contractor is not sufficient to determine the worker’s status.
• Benefits. Businesses providing employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay have employees. Businesses generally do not grant these benefits to independent contractors.
• The permanency of the relationship is important. An expectation that the relationship will continue indefinitely, rather than for a specific project or period, is generally seen as evidence that the intent was to create an employer-employee relationship.
• Services provided which are a key activity of the business. The extent to which services performed by the worker are seen as a key aspect of the regular business of the company.

What if the classification is wrong?

Classifying an employee as an independent contractor with no reasonable basis for doing so makes employers liable for employment taxes. Certain employers that can provide a reasonable basis for not treating a worker as an employee may have the opportunity to avoid paying employment taxes. In addition, the Voluntary Classification Settlement Program (VCSP) offers certain eligible businesses the option to reclassify their workers as employees with partial relief from federal employment taxes.

The IRS can help employers determine the status of their workers by using Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

Contact experts at ‘CFO Plans’ to discuss the exact scenarios in hand. If your finance back office is managed by ‘CFO Plans’ it is all part of the service.