States are cracking down on companies that misclassify their employees as independent contractors, Bloomberg reports. Labeling someone an independent contractor means companies don’t have to withhold or pay income taxes, Social Security and Medicare taxes, or unemployment taxes. But revenue-hungry states are looking more closely into worker classification in an effort to get tax payments from employers.
Of course, many misclassifications happen due to honest error, because the line dividing employee from independent contractor is often hazy. Here are the guidelines you need to know.
In general, the IRS considers someone an independent contractor if your business has the right to control or direct only the result of the work you hire them to do, but not what will be done and how it will be done. The IRS bases the determination on three criteria:
- Behavioral. Is the work actually done on your premises? Do you provide the equipment or tools needed to do the work? Do you instruct the person on a daily basis? If so, they are more likely an employee. On the other hand, if the person works at his or her office, using his or her equipment and deciding how the work will be done, they’re more likely an independent contractor.
- Financial. Does the person buy the equipment or tools to do the work? Does he or she handle the expenses involved (such as buying supplies or paying a phone bill), or do you reimburse the person? Do you pay the person a salary or do you pay per project? Are you the person’s sole source of income or does he or she do the same type of work for other clients?
- Relationship. Do you have a contract with the person? If so, does it specify a beginning and ending date for the relationship, or focus on a specific project to be delivered? If so, the person is more likely to be an independent contractor. Do you provide benefits to the person, such as life or health insurance or paid time off? If so, the person is more likely to be an employee.
Clearly, there are lots of gray areas here. If you have doubts about how to classify someone, talk to your accountant and if you are still uncertain, file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS. They’ll determine the worker’s status, which can take up to six months, but will put your mind at ease.