Freelancers, consultants, “work for hire” specialists, home-based and other workers are sometimes confused about whether the IRS sees them as an employee or an independent contractor when it comes to the arrangements they made with the companies paying them for their work. The IRS rules can be unclear and easily misinterpreted by workers and companies. This is especially true when it comes to paying taxes, reporting income and claiming deductions.

The IRS has developed form for certain workers to use when they should have been classified as employees and paying employment taxes accordingly. According to the IRS, “Form 8919, Uncollected Social Security and Medicare Tax on Wages, will be used by workers who performed services for an employer but the employer did not withhold the worker’s share of social security and Medicare taxes.” In other words, this form basically allows or forces these individuals to “report” the businesses that misclassified them.

The question of whether a worker is an independent contractor or employee for federal income and employment tax purposes is a complex one. It’s intensely factual, and the stakes can be very high.

It’s commonly known that if a worker is an employee, the employer must withhold federal income and payroll taxes, pay the employer’s share of FICA taxes on the wages plus FUTA tax, and often provide the worker with fringe benefits it makes available to other employees. There may be state tax obligations as well.

These obligations don’t apply to independent contractors. The business may choose to send an independent contractor a Form 1099-MISC for the year showing what he or she was paid (if it amounts to $600 or more), and that’s it.

Who’s an “employee?” There is no uniform definition of the term.

Under the common-law rules (so-called because they originate from court cases rather than from the tax code), an individual generally is an employee if the enterprise he works for has the right to control and direct him regarding the job he is to do and how he is to do it.

Individuals who are “statutory employees,” (that is, specifically identified by the tax code as being employees) are treated as employees for social security tax purposes even if they aren’t subject to an employer’s direction and control (that is, even if the individuals wouldn’t be treated as employees under the common-law rules). These individuals are agent drivers and commission drivers, life insurance salespeople, home workers, and full-time traveling or city salespeople who meet a number of tests. Statutory employees may or may not be employees for non-FICA purposes. Corporate officers are statutory employees for all purposes.

Who’s an “independent contractor?”

Individuals who are statutory independent contractors (that is, specifically identified by the tax code as being non-employees) aren’t employees for purposes of wage withholding, FICA or FUTA, and the income tax rules in general. These individuals are qualified real estate agents, freelance designers and writers, photographers, certain commercial and residential painters and carpenters, several categories of direct sellers, contracted security guards, and other types of workers who are not under company supervision, control or direction.

Here’s an example of where it all gets fuzzy.

A freelance graphic designer has established her own sole proprietorship and has set up a complete office in her home. However, she does design work every week for one of her clients, a larger corporation, and works on location at that company, using the company’s equipment and doing the same work as other freelancers and on-staff graphic designers. She also needs to follow the same design protocols and production schedules as the rest of the team. This arrangement meets the IRS’s definition of an employee because the freelance designer’s “co-workers” are performing similar services under similar direction and control and are treated as employees.

Under the IRS requirement, this graphic designer would need to complete Form 8919 to figure and report the employee’s share of uncollected social security and Medicare taxes due on their compensation. The designer’s social security and Medicare taxes will be credited to their social security record (the IRS will electronically share Form 8919 data with the Social Security Administration). Therefore, she may end up paying less in self-employment taxes, but the employer (her “client company”) may have to pay more.

Some employers that have misclassified workers as independent contractors are relieved from employment tax liabilities under Section 530 of the ’78 Revenue Act (not the Internal Revenue Code). In brief, this protection applies only if the employer:

  • filed all federal returns consistent with its treatment of a worker as an independent contractor;
  • treated all similarly situated workers as independent contractors; and
  • had a “reasonable basis” for not treating the worker as an employee.

The “client company” in the above example should work with a tax lawyer to take the appropriate steps.

If you feel that you may be a misclassified employee or an employer facing this issue and you need assistance, please call us for guidance at 207-774-0882.

Our financial articles are presented by Honeck O’Toole, Maine-based certified public accountants. If you ever have questions about your finances, please email us or call 207-774-0882.

If you’d like help in looking at your financial picture and mapping out a plan, make an appointment with a financial planner here at Honeck O’Toole.

Call us at 207-774-0882