There are two main classifications of workers in the United States: contractors and employees. You may believe that correctly categorizing workers isn’t a priority; however, this is untrue. The IRS closely monitors the payment of workers as both contractors and employees are paid differently.
The importance of correct classification, tests to uncover the classification, and the penalties of misclassification are all essential to avoid fines and penalties imposed by the IRS.
The Importance of Differentiating
Independent contractors and employees are not only paid differently, but there are also discrepancies in the employer’s obligation to withhold payroll taxes. Employees work directly for you, meaning you are responsible for collecting and remitting employee and employer payroll taxes. On the other hand, independent contracts are responsible for their own tax withholding with no requirement to remit taxes on the employer side.
There are also different year-end forms you must file for each worker category. Independent contractors will be issued a 1099-NEC, which outlines all the payments you made during the year. On the contrary, employees are issued W-2s that have more information regarding the taxes withheld and benefits offered. These forms will be reported on their individual return, altering the way they are taxed.
How to Correctly Classify Your Labor
The IRS understands that correct classification is difficult for many employers, which is why they have outlined 3 tests that employers should go through to differentiate between workers, called the Common Law Rules.
- Behavioral – Do you control the daily tasks of the worker, including the methods used to complete tasks? If you control the daily duties, you have an employee.
- Financial – Are you in control of how the worker is paid, including the schedule and payment method? Do you reimburse expenses and provide tools? If you provide the supplies used on a daily basis and control the pay schedule, you have an employee.
- Type of Relationship – Do you offer the worker benefits, such as vacation time? Is the work for an indefinite period? If the worker is offered benefits and there is no set end date, you have an employee.
These rules can be used to differentiate between worker classes; however, if you are still unsure of what worker you are dealing with, you can contact the IRS or a qualified accountant who can assist.
The Penalties of Misclassification
Misclassifying workers not only have a monetary impact on you, but the worker might also face fines and penalties for mistakes on their individual tax return. When you have no reasonable basis for classifying an employee as an independent contract, the IRS can hold you liable for back payroll taxes with fines and penalties.
In addition, you can also face fines and penalties for filing the wrong year-end forms. These fines can be up to $1,000 per misclassified worker and 1 year in prison. Clearly, the IRS does not take misclassification lightly, meaning you want to be sure you are properly classifying your workers.
Summary
Proper classification of your workers is crucial to avoid high fines and penalties with the IRS. There are gray areas when it comes to differentiating between worker classes, making expert guidance recommended. The team at Gordian Financial understands the tax law surrounding worker classification, giving them the resources and knowledge to properly advise you. Reach out to a team member today for more information.
