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Are Your Employees Really Employees?


Do you have employees or independent contractors? It's not always an easy question to answer, but the IRS insists you get it right, because there's a huge difference in how you should treat them. Fortunately, the IRS has some guidance.

The government recognizes five different kinds of workers:

Independent contractors. Those who offer their services to the general public are generally independent contractors. The general rule is that an individual is working as an independent contractor if the person who is paying him or her has the right to control or direct only the result of the work and not what is done and how it is done.

Employees. Under common-law rules, anyone who performs services for you is your employee if you can control what they do and how they do it. This is the case even when 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 employees. Some independent contractors may nevertheless be treated as employees by statute for certain employment tax purposes if they fall within certain categories and meet certain conditions. The categories for statutory employees are:

  • Various delivery drivers.
  • Full-time life insurance sales agents whose principal business activity is selling life insurance or annuity contracts or both, primarily for one life insurance company.
  • Individuals who work at home on materials or goods that you supply.
  • Full-time traveling or city salespeople who work on your behalf and turn in orders to you from wholesalers, retailers, etc.

You must withhold Social Security and Medicare taxes from the wages of statutory employees if all three 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.
  • The services are performed on a continuing basis for the same payer.

Statutory nonemployees. There are three categories of statutory nonemployees: direct sellers, licensed real estate agents and certain companion sitters. Direct sellers and licensed real estate agents are treated as self-employed for the purposes of all federal taxes, including income and employment taxes, if both of these conditions are met:

  • Substantially, all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked.
  • Their services are performed under a written contract providing that they will not be treated as employees for federal tax purposes.

The IRS further advises that companion sitters who are not employees of a companion-sitting placement service are generally treated as self-employed for all federal tax purposes.

Government employees. These are generally treated like employees. The government entity withholds taxes and issues an annual Form W-2.

Where to draw the line

The main question is: What is the difference between an employee and an independent contractor? The government has some additional guidelines:

  1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
  2. Financial: Are the business aspects of the worker's job controlled by the payer? These include things like how the worker is paid, whether expenses are reimbursed and who provides tools and supplies.
  3. Type of relationship: Are there written contracts or employee-type benefits such as a pension plan, insurance or vacation pay? Will the relationship continue, and is the work performed a key aspect of the business?

The IRS stresses that businesses must weigh all these factors when determining whether a worker is an employee or an independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor.

Says the IRS: "There is no 'magic' or set number of factors that 'makes' the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another."

If this sounds confusing, it is! In fact, this article is just a summary — there are many additional provisions and exceptions, and new regulations or lawsuits may change the situation. If there's any doubt in your business, keep in touch with legal and financial professionals to make sure you're in compliance.

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Davis & Graves CPA, LLP
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Our firm provides the information in this e-newsletter for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this e-newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.
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