Classifying Your Employees

One of the ways that small business owners get in trouble is classifying employees as independent contractors. The U.S. Small Business Administration advises on knowing the difference, because errors on your part can result in legal and tax problems.

There are different categories of workers: independent contractor, employee (also known as common law employee), statutory employee, and statutory nonemployee.

Independent Contractor

According to the IRS’s site, “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 and not what will be done and how it will be done. You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed.”

Common-Law Employee

A common-law employee is someone who performs services for you. If you can control what will be done and how it will be done, then that person is a common-law employee even if you give the employee freedom of action. “What matters is that you have the right to control the details of how the services are performed.”

Statutory Employee

A statutory employee is someone who is an independent contractor under the common law rules, but treated as an employee for employment tax purposes. However, they have to fall under one of the following categories and meet three of the conditions in the Social Security and Medicare taxes.
Categories (from IRS site):

• A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.

• A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.

• An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done.

• A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer’s business operation. The work performed for you must be the salesperson’s principal business activity.

You can withhold social security and Medicare taxes for a statutory employee if all of the following conditions apply:

• The service contract states or implies that substantially all the services are to be performed personally by them.

• They do not have a substantial investment in the equipment and property used to perform the services (other than an investment in transportation facilities).

• The services are performed on a continuing basis for the same payer.

Statutory Nonemployee

Direct sellers, licensed real estate agents, and certain companion sitters fall under this category. Payments for their services (direct sellers and real estate agents) are directly related to sales or other output rather than the number of hours worked, and their services are performed under a written contract providing they will not be treated as regular employees for federal tax purposes.

Clear as Mud?

If it is still unclear which category the worker falls under, then you can fill out a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding (PDF). However, it can take up to six months to get a determination. If you continually hire the same type of worker to perform particular services, then you may want to consider filling out the form.

Consequences for Misclassification

If you classify an employee as an independent contractor, you may be held liable for employment taxes. However, relief provisions exist as well as the Voluntary Classification Settlement Program for employers who have a reasonable basis for not treating a worker as an employee or who need to reclassify their workers as employees for future tax periods and get partial relief from federal employment taxes.

Employers may also need to reimburse the worker for wages that should have been paid under the Fair Labor Standards Act which include overtime and minimum wage requirements. You may also be liable for any injured worker that was misclassified, as well as any employee benefits that the worker missed out on.

For more information on employee classifications, visit www.sba.gov and www.irs.gov.

Story by Jennifer Taylor

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