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How do you determine if a worker is an employee or an independent contractor

Worker classification is important because it determines if an employer must withhold income taxes and pay Social Security, Medicare taxes and unemployment tax on wages paid to an employee. Businesses normally do not have to withhold or pay any taxes on payments to independent contractors.

Often employees of a company are eligible for fringe benefits and may be subject to employment and labor laws where independent contractors may not.  As you might expect, hiring independent contractors may result in some significant savings to the company, but there are rules to determine the proper classification of worker.

There are three basic categories of factors that are relevant to determining a worker’s classification:

The first is behavioral control.  A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised.  The IRS will examine several behavior control factors such as type of instructions given, degree of instruction, evaluation systems and whether the business provides training for the work to be performed.

The second is financial control. Financial control refers to facts that show whether the business has the right to control the economic aspects of the worker’s job.  These aspects include things such as investment in equipment used to perform the job, how expense reimbursements are handled, whether there is an opportunity for profit or loss and the method of payment for the work performed

The third is the relationship of the parties. The type of relationship depends upon how the worker and business perceive their interaction with one another.  These factors generally fall into the categories of written contracts, fringe benefits, permanency of the relationship and whether the services performed are a key aspect of the business.

Worker classification can be a challenge and it is important to get it right as the potential costs and penalties for getting it wrong can be significant.  FMA CPA can help you get it right.

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