Supposed you hire several “outsiders” to do some “inside” work. Are they employees or independent contractors? It can make a big tax difference.

Alert: The IRS is cautioning small business owners about misclassifications. It recently issued a reminder about the basic guidelines for determining the employment status of workers (IRS Small Business Week Tax Tip 2017-02, 5/1/17).

This isn’t small potatoes. If the IRS discovers an error, it will assess back federal employment taxes for the years in question, plus interest and penalties.

Here’s the whole story:  If a worker is treated as an employee, the business must withhold federal income tax and the employee’s share of Social Security and Medicare taxes (collectively the FICA tax) from his or her wages. In addition, the business had to pay its share of Social Security and Medicare taxes plus federal unemployment tax (FUTA). Finally, your small business is required to issue a Form W-2 to the employee, providing the relevant information. The IRS gets a copy.

On the other hand, if a worker qualifies as an independent contractor, your business isn’t responsible for federal income tax withholding and doesn’t owe Social Security, Medicare, or FUTA taxes on the worker’s wage. What’s more, your business doesn’t have to provide costly fringe benefits – such as health insurance, 401 (k) plans and group-term life insurance – to those workers. For these reasons, this setup is generally preferable to small business owners.

How do you determine if a worker is an employee or independent contractor? In the new Tax Tip, the IRS emphasizes two key factors.

  1. Control: The relationship between a worker and a business is important. If the business controls what work is accomplished and directs how it is done, it exerts behavioral control. If the business directs or controls financial and certain relevant aspects of a worker’s job, it exercises financial control. This includes the following:
  • The extent of the worker’s investment in the facilities or tools used in performing services
  • The extent to which the worker makes his or her services available to the relevant market
  • How the business pays the worker (by the job or by the hour, day, week, or month)
  • The extent to which the worker can realize a profit or incur a loss.
  1. Relationship: How the employer and worker perceive their relationship is also significant in determining worker status. Some of the key issues to think about include the following:
  • Written contracts describing the relationship the parties intended to create
  • Whether the business provides the worker with employee type benefits, such as insurance, a pension plan, vacation or sick pay
  • The permanence of the relationship
  • The extent to which services performed by the worker are a key aspect of the regular business of the company.
  • The extent to which the worker has unreimbursed business expenses.

Finally, the IRS reminds employers that it can help determine the status of their workers by using form Form 22-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. That said, if you ask the IRS to determine the status of a worker, expect the answer to be that he or she is an employee. The IRS is not an unbiased third-party here. IRS Publication 15-A, at, is a helpful resource on the worker classification issue. Tip: For a close call, consult with your tax pro.

Source: Business Management Daily, August 2017