The purpose of this paper is to differentiate between an employee versus independent contractor and then illustrate the difference between these in the tax based issues. Competition from both domestic and international market has forced the companies in U. S. to lower down their operating costs while maintaining quality standards, productivity and efficiency level and this is most fluently and successfully done through cutting down labor costs in the U. S. employment market.
Downsizing and reengineering are becoming standard operating practices.
Many companies since quite a time are achieving this objective through terminating their permanent employees and hiring the independent contractors on contract basis. In this way they are exempted from tax payments as well as the rising health and other benefits costs paid to the permanent employees in U. S. However, there can be major legal and tax risks associated with such practices if they violate the Internal Revenue Service’s definition of an employee.
One of the IRS’s most controversial issues in recent years is the reclassification of a worker’s status from an employee to an independent contractor.
The IRS claims it loses millions of dollars each year due to such improper classifications, particularly with the number of independent contractors in the U. S. at five million and rising. An advantage of labeling a worker as an independent contractor is that it lowers an employer’s tax obligation, since the employer does not have to pay the contractor’s Federal Insurance Contribution Act (FICA) or Federal Unemployment Tax Act (FUTA) taxes.
Moreover, administrative costs of complying with the tax laws are greatly reduced because the employer is not required by law to provide employee benefits (vacation pay, sick leave, health insurance, pension contributions) to an independent contractor. One of the most perplexing aspects of the debate is the legal view regarding how a worker should be classified. The common law classification between the two types is often contradictory and vague.
No single rule or test distinguishes whether a worker is an employee or an independent contractor. This is primarily because the relationship between a company and its workers is unique. Every decision of whether a worker is an employee or a contractor must be made on a case-by-case basis. Employee versus Independent Contractor The term “employee” is defined in three different sections of the IRS code relating to employment taxes.
The Section 3121(d) definition for FICA tax purposes contains the broadest of the three: a corporate officer; an agent or commission driver who distributes meat, vegetables, fruit, bakery goods, beverages (other than milk), laundry, or dry cleaning; a full-time life insurance salesman; a home worker performing work under the specifications of the person who provides the materials or goods, which are required to be returned to such person or a person designated; or a traveling salesman, engaged full-time to solicit orders for his principal.
With the exception of the corporate officer, all other classes of these workers must meet three additional requirements as stated in Code Sec. 3121 (d) (3) before being classified as employees for FICA purposes: (1) they must personally and substantially perform all the services for remuneration; (2) they must not retain a substantial investment in the facilities to be used; and (3) they must continue the relationship on an ongoing basis. On the other hand an independent contractor is a person, business or corporation which provides goods or services to another entity under terms specified in a contract.
Unlike an employee, an independent contractor does not work regularly for an employer but works as and when required during which time, he or she may be subject to the Law of Agency. Contractors often work through a limited company which they themselves own, or may work through an umbrella company. If the one who pays for the labor and services of another has the right to control what will be done and how it will be done, this other person is an employee. This will be so even though the employee has been given some degree of freedom of action.
The key determinant is the existence of the right to control the details of how any work is done. Whether such control is actually exercised is irrelevant. If the one paying for the work does not have the right to control the day-to-day working but merely to direct the desired result, the person supplying the labour is an independent contractor. For example, if a builder uses the in-house employees for basic construction but hires in specialists for electrical, plumbing, plastering, and decorating work as and when required, these are likely to be independent contractors.
One clear sign will be whether such individuals are entered in the payroll system and paid as other employees, or paid when the work contracted for is completed and certified of satisfactory quality. Another major difference between an employee and an independent contractor is that an organization has to pay complete health benefits to its employee whereas to independent contractors there are no health benefits given which is also one of the main reasons why organizations these days prefer independent contractors more than employees because a burden on small business is the uncontrollable costs of employee health benefits.
The average total cost of health benefits for U. S. employees was $6,215 in 2003. To interpret Treas. Reg. 31. 3401(c)-1(b), the IRS issued Revenue Ruling 87-41, which lists 20 factors the IRS uses in determining the correct classification of a worker’s employment status. I am in this report mentioning some of the important factors that would clearly indicate the difference between employee and independent contractors. They are as follows: 1) If the person for whom the services are rendered has the right to instruct the worker how, when, and where to work, then the worker is ordinarily an employee.
This control factor is present if the employer retains the right to require compliance with the instructions, irrespective of whether the employer actually exerts the right to control. The instructions can be either oral or in the form of manuals and/or written procedures that state the details and means in which the result is to be achieved. In contrast, an independent contractor is responsible only for the end result. 2) An employer trains workers by requiring them to work with experienced employees, holding training meetings, corresponding with them, or any of several other methods.
By training a worker, the employer explicitly or implicitly states that the services to be rendered must be performed in a particular manner. The employer demonstrates a right to control by teaching the worker to achieve the desired results in that manner. Independent contractors, however, use their own methods and means to obtain a result and do not receive training from an employer. 3) If a worker’s services are integrated into the business operations, then the worker is generally subject to direction and control.
When the success or continuation of a business depends to an appreciable degree on the performance of certain services by a worker, those services are assumed to be subject to a certain amount of control by the employer. 4) The requirement that services must be rendered personally by the worker indicates that the employer is interested in the methods used to accomplish the work as well as in the result. Generally, inability to delegate the services to another individual indicates that the employer controls the details and means by which a result is to be achieved. ) If the employer hires, supervises, and pays a worker’s assistants, then the employer has control over those assistants and the worker should be considered an employee. However, if the worker hires, supervises, and pays his own assistants and provides the employer with materials and labor under a contract in which the worker is responsible only for the results, he is an independent contractor. 6) Continuous interaction between the worker and employer indicates an employee relationship. Such a relationship may exist in which work is performed at frequently recurring, though irregular, intervals. )
Establishing certain hours in which a worker is to perform a job indicates an employer’s control. The fact that an employer can dictate a worker’s hours is indicative of an employee relationship. 8) If a worker must devote full time to the employer’s business, the employer has control over the amount of time the individual actually spends working and, by implication, restricts the worker from performing other gainful work. In contrast, independent contractors are free to work when and for whom they choose. ) Workers required to perform their services on the employer’s premises when the work could be performed elsewhere are under the employer’s control, which is beyond that which would ordinarily be exerted over an independent contractor. The importance of this factor depends on the nature of the services involved and the extent to which an employer generally requires its employees to perform services on its premises. Control over the place of work is indicated when the employer compels the worker to travel a designated route, canvass a territory within a certain time, or work at a specific place. 0) If an employer has the right to indicate the order or sequence in which work is to be performed, then the worker is probably an employee, particularly if the same results can be achieved in a different order or sequence.
11) When a worker is paid by the hour, week, or month and such payment is guaranteed, whether or not certain results are achieved, the worker is generally an employee. In contrast, payments made by the job or on a straight commission basis generally indicate that the worker is an independent contractor. 2) The IRS is of the view that when an employer pays a worker’s business or traveling expenses, the worker is ordinarily an employee. Conversely, a worker who is paid on a job basis and must pay all incidental expenses is generally an independent contractor. 13) If the employer furnishes tools, materials, and other equipment for a job, this indicates that the worker is an employee. Independent contractors ordinarily furnish their own tools and materials. In determining what the classification should be, the value of the tools and materials supplied to the worker should be considered as well. 4) A significant investment by a worker in the facilities used in performing services for another is a factor that often establishes an independent contractor relationship.
Conversely, the lack of investment in facilities indicates a dependence on the employer for the facilities which means an employee relationship, exists. 15) A worker who stands the risk of suffering a financial loss or realizing financial gain as a result of providing services to the employer is generally an independent contractor. In contrast, a worker who has no risk of financial loss is usually an employee. 6) If a worker performs services for more than one unrelated person or firm at the same time, it generally indicates that the worker is an independent contractor. 17) Workers who make their services available to the general public on a regular and consistent basis are usually independent contractors. 18) Employers generally possess the right to discharge only employees.
The threat of dismissal demonstrates a degree of control over workers. In contrast, the IRS’s viewpoint is that independent contractors cannot be fired unless they violate the terms of the contract for services rendered. 9) If the worker providing the services can terminate the relationship with the employer at any time without incurring liability, an employee relationship usually exists. Conversely, an independent contractor engaged to accomplish a task or provide a service may incur a legal liability if the relationship is unilaterally terminated before the results of the task are accomplished. Employee versus Independent Contractor: Tax issue Due to the subjective nature of a worker’s employment status and the exorbitant costs of misclassification, Congress has attempted to provide a safe haven rule in Section 530 of the 1978 Revenue Act.
The Act was promulgated to protect employers who have consistently treated workers as independent contractors from the reclassification of their work force to employees. Although Sec. 530 has not been permanently codified in the Internal Revenue Code, it serves as a permanent relief provision under the current tax system. An employer is relieved of liability for back taxes, penalties, and interest when Sec. 530 is applicable. Sec. 530 allows workers to be treated as independent contractors only for federal employment and withholding tax purposes.
So a worker could be statutorily defined as an independent contractor under Sec. 530 but defined as an employee under common law in determining the status of a qualified pension, profit sharing, or stock bonus plan. The reclassification of a contractor to an employee could disqualify the employer’s pension plan and other employee benefits as a result of violating nondiscrimination requirements. Moreover, if a contractor is considered an employee under common law, business expenses for the worker would be deducted “above the line” and subject to the 2 percent floor rule.
Payments to an independent contractor that total $600 or more for the tax year must be reported by the business owner on Form 1099-MISC, “Miscellaneous Income,” and filed with the IRS. A copy also must be given to the independent contractor. When we talk about tax payments and employees the statuary law states that the employer must withhold federal income tax from your employee’s wages. To figure how much to withhold from each wage payment, use the employee’s Form W-4 and the methods described in Publication 15, Employer’s Tax Guide and Publication 15-A, Employer’s Supplemental Tax Guide.
Social security and Medicare taxes pay for benefits that workers and families receive under the Federal Insurance Contributions Act (FICA). Employers also withhold part of these taxes from employee’s wages and pay a matching amount. The federal unemployment tax is part of the federal and state program under the Federal Unemployment Tax Act (FUTA) that pays unemployment compensation to workers who lose their jobs. Employers report and pay FUTA tax separately from social security and Medicare taxes and withheld income tax. Employers pay FUTA tax only from their own funds for their employees.
Employees do not pay this tax or have it withheld from their pay. To encourage prompt payment of withheld income and employment taxes, including social security taxes, railroad retirement taxes, or collected excise taxes, Congress passed a law that provides for the TFRP. These taxes are called trust fund taxes because employer does actually hold the employee’s money in trust until they make a federal tax deposit in that amount. If an employer is forced to reclassify a worker from an independent contractor to an employee, the employer should attempt to mitigate the deficiency for back taxes, interest, and penalties.
The IRS does provide some statutory provisions that ease the employer’s increased tax liability due to a retroactive reclassification. The relief provided in Code Sec. 3509 reduces the amount of income tax withholding and the employee’s share of FICA taxes that would ordinarily be due. The amount assessable depends on whether the employer filed the worker’s Form 1099 on time. If so, the amount assessable is 1. 5 percent of the wages paid for income tax withholding and 20 percent of the employee’s share of FICA taxes.
If not, the amount increases to 3 percent of the wages paid for income tax withholding and 40 percent of the employee’s share of FICA taxes. Sec. 3509 does not reduce an employer’s liability for its portion of FICA and FUTA taxes. Nor does it operate to relieve an employer from any interest or penalties imposed as a result of misclassification. The IRS code cites several instances in which Sec. 3509 cannot be used by an employer. One is when the failure to treat the workers as employees was due to an “intentional disregard” of the applicable rules. A second is when the employer deducts income tax withholdings but does not deduct FICA taxes.
If the reclassification of a worker takes place according to Sec. 3121(d)(3), Sec. 3509 is rendered ineffective. Conclusion An employer should constantly evaluate the employment status of its workers to ascertain if any of them should be reclassified from an independent contractor to an employee. Misclassifying a worker could end up being quite costly in terms of time, money, and resources. If an employer is forced to reclassify independent contractors as employees, the payment of back taxes, penalties, and interest could create major financial problems. Ultimately, the risks of incorrect classification are borne by the employer.
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