In today's economy, many Americans are happy to have a job and therefore may pay little attention to how their employer classifies them on federal forms. While it is an employer's responsibility to abide by Internal Revenue Service guidelines governing how workers are treated for tax purposes, it's still critical for workers to also ensure they are being defined correctly to earn the tax benefits they deserve or avoid penalties and legal inquiries.
A worker is generally put into one of two classes: Employee or independent contractor. An employee has payroll taxes withheld from each payment, and is generally eligible for benefits that may include access to employer-sponsored healthcare, retirement benefits, vacation and PTO, life insurance and unemployment benefits. In contrast, a contractor does not have taxes withheld from each paycheck, and must instead make quarterly payments to the IRS. Additionally, these workers are not benefits-eligible. Over the years, many small businesses have faced greater scrutiny from the IRS for misclassifying employees as contractors in order to save money on payroll taxes and benefits. However, a lot of these cases are the result of confusion over these statuses, rather than blatant compliance violations.
Tests to determine worker status
The definitions associated with each of these classifications can be hazy at times, which makes it challenging in some instances for employers to determine into which rank a worker falls. However, there are three tests that the IRS offers to help both companies and workers avoid missteps: Behavioral control, financial control and type of relationship.
With regard to behavioral control, an employee's tasks and the way in which functions must be performed are controlled directly by an employer. Companies also provide training, tools and resources to employees to help them perform their responsibilities. Contractors, in contrast, have more independence over how their work is performed, usually set their own hours and provide their own resources.
In terms of financial control, companies also dictate how and when employees are paid, while contractors invoice the company after completing a work project. Lastly, the IRS will examine the type of relationship that exists between individuals to determine worker status. For instance, employees typically work for a single employer and signs an employment contract that dictates their roles and responsibilities. Contractors often have a number of clients and have more flexibility in determining the details of project contracts and employment lengths.
As the rules that are used to define workers can be complicated in some instances, it can be helpful for those who are labeled contractors to speak with a tax preparer to ensure they are being classified properly.
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