As businesses expand their operations and workforce, they may rely on a combination of employees and independent contractors to carry out day-to-day tasks. And depending on how workers are classified, their relationship to the business is treated differently. Taxation is also handled differently, so it’s important for companies to classify their workers appropriately.

Unsure of whether a worker is an employee or independent contractor? Let’s clarify which classification is appropriate and what employers should expect from a taxation perspective.

If there is any confusion, business owners are encouraged to consult with a Houston tax professional first. Tax experts like CPAs and some attorneys can use established precedent to guide their clients into classifying workers properly.

Guidelines for Classifying Workers as Employees or Independent Contractors

There are two primary buckets that workers may be placed in – either as an employee or as an independent contractor. There are three factors used to make this determination – behavioral, financial and relationship. The idea is to determine which party (either the worker or employer) has control over how services are provided. Here’s a closer look at each factor involved:

• Behavioral factors – Behavioral factors address who has control over how and when the worker provides services. There are two considerations here – what instructions the employer gives to the worker, and what training the employer provides. 

If the worker is an employee, the employer generally reserves the right to determine when and where the employee will perform their duties. The employer also determines what tools and equipment will be used to perform the job, who their employees will work with, what specific duties the worker will provide and the order in which those tasks are to be accomplished. If the worker is an independent contractor, they will have much more control over these details, including choosing when to work, what they use to do the job and what order they take on tasks.

Training is the other major behavioral factor. If the employer trains the worker to perform their duties in a particular manner, they are likely an employee. If the worker brings their own methods to the job, they are likely an independent contractor.

• Financial factors – Financial factors address to what extent the employer may control the business aspects of a worker’s job. The worker’s unreimbursed expenses, their investment into the business, their availability to other clients, the payment method used to compensate the worker and whether the worker takes on a profit or loss – these are all used to determine the worker’s status. 

If the worker is an employee, their employer is generally responsible for work-related expenses. Independent contractors are responsible for their own overhead and expenses. Employees are usually (but increasingly less often) provided with a place to work, while independent contractors furnish their own home office or other work area. Employees may be barred from working jobs for other businesses in the same industry, while independent contractors are generally free to pursue other clients as they see fit.

Employees are guaranteed a regular wage and work on an hourly or salary basis. Independent contractors more often charge a flat fee for their services. As such, employees are guaranteed profitability for their time and skill, while independent contractors must work to ensure their own profitability.

• Relationship factors – Additional relationship factors may also come into play. For example, the employer may provide the worker with a written contract that explains the nature of the worker/employer relationship. This contractor may specify whether the worker is considered an employee or independent contractor in relation to the business. 

The permanency of the professional relationship – employees are typically tied to the employer indefinitely, independent contractors are not – and whether additional benefits are offered also influence the employee/contractor distinction.

How Employees are Treated for Taxation and Income Reporting Purposes

If the worker is identified as an employee, they are provided with a W-2 (Wage and Tax Statement) for income reporting purposes. Employers are required to withhold income tax and FICA (Social Security and Medicare) from the employee’s pay and are also responsible for unemployment taxes and various state taxes.

Employees are also eligible for additional fringe benefits, such as health care.

How Independent Contractors are Treated for Taxation and Income Reporting Purposes

Independent contractors are provided with a 1099-NEC (Nonemployee Compensation) for income reporting purposes, which serves a similar purpose as a W-2. 1099s are only provided to contractors whom the business paid more than $600 to for services during the tax year.

Independent contractors are responsible for paying their own taxes through estimated tax payments. Employers are not responsible for withholding income or FICA taxes.

The Consequences of Improperly Classifying a Worker

Businesses may be incentivized to classify employees as independent contractors instead, but there can be serious ramifications for doing so if the IRS comes to a different conclusion.

If the IRS reclassifies an independent contractor as an employee, the employer will be responsible for the following:

• Unpaid FICA and unemployment taxes
• Penalties for failure to withhold and remit income taxes
• Interest on unpaid amounts
• Penalties for failure to file information returns
• Workers’ compensation (state level)
• Unemployment compensation premiums for unreported wages (state level)

If an employer sends an employee a 1099 instead of a W-2, that employee may either accept independent contractor status and pay self-employment taxes, or they may file Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) with the IRS. If they do the latter, the IRS will review the available information and make a final determination regarding the worker’s status. Based on this determination, either the employer (FICA, unemployment) or worker (self-employment) will be required to remit taxes to the agency.

Work with a Reputable Houston Tax Expert to Properly Classify an Employee or Independent Contractor

Employers have options when adding labor to their team, but that labor must be properly classified – either employee or independent contractor – for taxation purposes. There are major financial consequences for failing to do so properly, but the line between employee and contractor isn’t always so clear. It’s recommended that the business make this determination before the IRS steps in and makes theirs. A CPA or Houston tax attorney can assist business owners with proper classification.