UPDATE: This post was updated on August 12, 2020, to include this link to an article from Forbes regarding a court ruling in California requiring Uber and Lyft drivers to be treated as employees, not independent contractors.
Importance of Correct Classification
The correct classification of a person as an employee or independent contractor is of great importance – an incorrect classification can be extremely costly. Mistakenly classifying an employee as an independent contractor with no reasonable basis for doing so makes employers liable for back employment taxes plus penalties. Intentionally misclassifying an employee as an independent contractor can bring additional penalties and even time in prison.
There have been many court cases on this issue and several tests have been created, but there is no one test that is applicable across industry and situation. Individual circumstances are considered; however, the Department of Labor lists these factors as being significant:
- The extent to which the services rendered are an integral part of the principal’s business
- The permanency of the relationship
- The amount of the alleged contractor’s investment in facilities and equipment
- The nature and degree of control by the principal
- The alleged contractor’s opportunities for profit and loss
- The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor
- The degree of independence of the business’ organization and operation
Example 1 – Painter
A painter is typically considered an independent contractor. Why?
- They work for many employers, not just one
- They provide their own equipment and materials
- They hire and direct their own employees
- They are typically paid by the job or project, not by the hour
Example 2 – Musician
A musician, especially in a church setting, is typically considered an employee. There has been much debate over this one, but let’s consider the facts and circumstances.
- The church sets the time for performances and rehearsals
- The church sets the location for performances and rehearsals
- The church typically has a music pastor who provides instructions about what music will be performed
- There is no opportunity for loss for the musician, only profit
While it is true that a musician typically provides his own instrument and may work gigs elsewhere during the week, enough of the controls exist to make the musician an employee even though not all of the items on the test list apply.
Example 3 – Minister
A minister is considered a hybrid when it comes to taxes. A minister employed by a local congregation is considered an employee for income tax purposes and should be issued a W-2, but is considered self-employed for Social Security and Medicare purposes.
Voluntary Classification Settlement Program (VCSP)
If you have been treating someone as an independent contractor, but you believe the person should be reclassified as an employee, the IRS offers the Voluntary Classification Settlement Program (VCSP). Under the VCSP, you can treat a person as an employee going forward and only pay 10% of the employment tax liability that would have been due for the most recent tax year and you will not be liable for interest for penalties.
Still unsure about the classification?
If you are simply unsure and would like the IRS to decide for you, the IRS has Form SS-8 for that purpose and they will issue a letter classifying the worker. Be aware, the IRS typically will determine the worker is an employee.
Employees should be issued Form W-2. Contractors should be issued Form 1099.
For more information or if you have questions regarding properly classifying your employees and contractors, explore the resources below or contact the experts at SST.
Special thanks to Simeon May, CPA CCA CAE, SST Manager of Client Accounting and Advisory Services, for providing the content for this post. Click here to learn more about Simeon.