Businesses that use independent contractors must be careful to observe federal tax laws regarding who does and who does not qualify for that designation — or they risk incurring significant financial penalties. Though sometimes the line between the two categories of workers can blur, the problem of misclassified independent contractors remains a high priority issue for the IRS.

Distinct Tax Obligations

For an employee, the business generally must withhold income and FICA (Social Security and Medicare) taxes from the employee’s pay and deposit the taxes with the government in a timely manner.

The business must also pay its own share of FICA taxes for the employee. These taxes can be significant. For 2017, the employer’s FICA share is equal to 7.65 percent of earnings up to $127,200 and 1.45 percent of earnings exceeding that amount.

In contrast, if the worker is an independent contractor, the business need not withhold federal income or FICA taxes — nor need it pay any FICA or federal unemployment taxes on the worker’s earnings.

Penalties

Because businesses have financial incentives for characterizing employees as independent contractors, the IRS has authority to impose heavy penalties for misclassifications. Businesses may be held liable for employment taxes for misclassified workers, and additional penalties may apply.

Proper Designation

To determine whether a worker is an independent contractor or an employee, the IRS examines the degree of control and independence in three broad categories — behavioral, financial, and type of relationship. No single piece of evidence —such as, for example, a written agreement expressly stating that the worker is an independent contractor — will control the determination.

An employer who is unsure about the proper classification can ask the IRS for a determination. Though these decisions may take six months or longer, a business that continually hires the same types of workers may want to consider filing IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

Correcting Mistakes

Employers with misclassified workers may be able to correct their mistakes through the IRS’s Voluntary Classification Settlement Program. The program gives eligible employers the opportunity to reclassify their workers as employees for future tax periods and obtain partial relief for unpaid federal employment taxes.

New Filing Deadlines

Generally, if a business has made payments of $600 or more to an independent contractor, it must file an information return (Form 1099-MISC) with the IRS and send a corresponding statement to the independent contractor.

For the 2016 calendar year, businesses must file Form 1099-MISC for non-employee compensation payments earlier than in prior years, and there will be no extensions for electronic filings. Paper and electronic versions must be filed with the IRS by January 31, 2017.

Please contact our tax advisors with any questions you may have about your tax obligations for employees and independent contractors.