Employee or Independent Contractor? Classify Workers Correctly
The IRS has publicly stated it is cracking down on organizations that improperly classify workers as independent contractors instead of employees. Are you confident that your employee classifications would stand up to IRS scrutiny?
Understand the Requirements
If a worker is an employee, your not-for-profit organization must provide a Form W-2 annually and withhold income tax and the employee's portion of Social Security and Medicare taxes from the employee's pay. You also must pay the employer portion of Social Security, Medicare and unemployment taxes on the employee's wages.
If a worker is an independent contractor, your organization generally should provide a Form 1099-MISC, which reports the amount you've paid to the person that year. The independent contractor is responsible for paying employment taxes (both the employee and employer portions) and income taxes on his or her own.
While the IRS generally should receive the same amount of total income and employment taxes regardless of whether someone is an employee or an independent contractor, the agency has found that it's more difficult to collect from independent contractors. Thus, the IRS tends to favor employee status.
Should the IRS determine you've improperly classified an employee as an independent contractor, you may be held liable for that worker's applicable employment taxes.
Take the Test
To determine whether a worker is an employee or an independent contractor, you must consider your nonprofit's degree of control and the person's level of independence. The IRS has assembled a number of questions to help employers decide. Commonly referred to as the "20-factor test" or "common law rule," the questions revolve around whether your organization:
- Has the right to control the individual and how that person performs his or her duties (that is, behavioral control),
- Whether there's a written contract between the individual and your not-for-profit organization;
- If the person receives employee benefits (that is, type of relationship);and
- Which aspects of the business relationship your organization controls (that is, financial control).
The IRS has suggested asking certain questions when determining status. For example, must a worker follow someone else's instructions regarding when, where and how he or she completes work? If so, the person is probably an employee.
More examples: Employees are typically trained how to perform a given job, whereas independent contractors are expected to already know how to do it. Independent contractors must pay their own assistants. And someone who retains the ability to set his or her own daily hours (within reason) is generally regarded as an independent contractor.
Another factor to consider is whether the person works for more than one business at a time, which would indicate contractor status. Someone paid by the hour, week or month (rather than by the job), on the other hand, typically signals employee status.
Be Aware Workers Can Go to the IRS
A worker or an employer can go to the IRS and ask for a determination on whether an individual is an employee or independent contractor. This is done by completing Form SS-8, "Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding."
Be aware that your workers could file one of these forms and bring his or her relationship with your organization to the attention of the IRS.
Filing an SS-8 is supposed to make it easy for employers to get a thumbs up or down on a worker's independent contractor status. Note, however, that while this program seems like a way to ascertain your organization is in compliance with the IRS, it is not a step to be taken lightly. By filling out an Form SS-8, and providing information about your relationship with workers, you may be inadvertently inviting the IRS to rule against you. This is an area where seeking the guidance of your tax advisor is highly advisable. Your tax advisor will be able to help you set up relationships with independent contractors that can stand up to IRS scrutiny.
If you inadvertently misclassify an employee as an independent contractor, you may be able to mitigate the consequences under the IRS's Voluntary Classification Settlement Program. Ask your tax advisor for details.
Meeting the Challenge
The IRS reported that it loses millions in unpaid taxes and uncollected penalties for misclassified workers each year -- and the tax agency is looking to get it back. Make sure your not-for-profit organization is following the rules.