One confusing aspect regarding paying workers in your business is the proper classification for them. Bookkeepers and business owners must ensure proper treatment to avoid dire consequences.
Hiring workers requires due diligence in many ways, including compliance with all applicable federal, state, and local laws.
Many businesses owe fines due to improper classifications. In this series, we want to help answer payroll and bookkeeping questions you may have about employee or independent contractor status.
Why is it important?
Serious consequences result from wrong treatment of workers. For instance, treating an employee as an independent contractor can result in significant fines and back taxes. Because payroll taxes are “trust funds,” the IRS aggressively pursues delinquencies. Therefore, it behooves all involved in the bookkeeping of a business to classify each worker correctly.
Employers withhold appropriate payroll taxes from each employee’s paychecks, and pay the employer’s portion of such taxes. For independent contractors, however, employers generally do not withhold any taxes.
Which Classification is Correct?
The determination of proper worker status must be based on a number of factors considered.
The IRS relied on a 20-Factor test for decades, now condensed into three basic categories: Behavioral, Financial and Relationship Type.
The first category, Behavioral, considers who has the greater control over the work and how it is done. Questions such as, “Who controls when the worker works,” and “How is the work being done,” are considered. Does the employer dictate when and where the work is done, or otherwise exercise significant control over the worker? Or, is the worker free to set their own hours and bear much control, so long as the job is completed properly and on time?
The next category, Financial, considers who bears the primary cost of the work and how is the worker paid. Is the worker paid on an hourly basis, similar to a regular employee? Does the employer or the worker pay the cost of materials and supplies? Is the worker paid regularly like the employees or perhaps by the job?
Lastly, what type of relationship exists between the employer and the worker? Are there any written contracts between them? Is the work done by the worker a key aspect of the business? Does this worker receive any fringe benefits from the employer?
Determining answers for these three categories for a worker helps bookkeepers clarify how to treat this individual.
How to treat
Once the proper determination is made for the individual, then appropriate reporting is required. Employees’ wages will be reported on Forms 941/944, W2, and Form 940, as well as the individual state’s required payroll forms.
Independent Contractors should be issued a Form 1099-MISC at year-end for all amounts that total $600 or more in payments to that individual for the year. Most businesses report the amount in Box 7. However, there are occasions where additional boxes may be used. This will be discussed in our 1099 series of articles.
In the next article, we seek to explain the 1099-MISC form in detail to help bookkeepers correctly prepare these forms.