There’s a fine line between employee and independent contractor. The distinction may take on even greater importance under the new tax law as some employees try to shift ordinary income into business income to be eligible for the new qualified business income (QBI) deduction. Here’s an overview of this issue and the characteristics that distinguish employees from contractors.
Worker classification affects tax revenue
If your company engages an independent contractor, it doesn’t need to withhold payroll or income taxes from his or her compensation. In addition, you don’t have to remit the company’s obligatory percentage of FICA or Medicare taxes, or pay into unemployment and workers’ compensation insurance.
So, when an employer misclassifies an employee as an independent contractor, the federal government potentially loses out on quite a bit of money. (Although the rules differ for states, state taxing agencies also look closely at this issue.) If the IRS determines you’ve committed employee misclassification, you could be liable for unpaid federal and state income tax withholding, Social Security, Medicare and unemployment insurance contributions, as well as penalties and interest.
Moreover, you could be on the hook for both your company’s share and the employee’s share of these amounts. And this may hold true even if you’ve filed Form 1099 and paid all taxes due.
It’s also important to remember that the federal government isn’t the only one that may raise the issue. Often, former workers who were classified as independent contractors will file lawsuits to recover employee benefits, overtime pay and unreimbursed business expenses or other amounts associated with employee status.
IRS considers various factors
To determine whether a worker is classified properly, the IRS asks three critical questions:
Does the company control the worker’s behavior? The agency looks at how, where and when job tasks are performed.
Does the company control the worker financially? When an independent contractor becomes largely or wholly dependent on a single entity to generate income, he or she starts to veer toward employee status.
What is the true nature of the company’s relationship with the worker? Informal agreements or those that go on for a long time can start to look like employment.
The IRS isn’t alone in its pursuit of employers who misclassify workers. The Department of Labor (DOL), under the Fair Labor Standards Act, also sets forth its “economic realities” test. For example, long, consistent interaction between the parties implies employee status. Similarly, if the services provided are integral to the business, the DOL will tend to view the independent contractor as an employee.
Contractor status gains popularity
The use of independent contractors is on the rise. Some manufacturers, for example, hire contractors for seasonal peaks or custom projects. In the past, workers were generally hesitant to be classified as independent contractors, because they didn’t want to forgo health and retirement benefits — or job security — that come with being an employee. However, thanks to the new QBI deduction under the Tax Cuts and Jobs Act (TCJA), more workers are expected to jump on the 1099 bandwagon.
From 2018 through 2025, self-employed individuals and contractors that operate so-called “pass-through entities” (such as partnerships, limited liability companies and S corporations) can take a deduction of up to 20% of QBI. Although the TCJA limits the QBI deduction for service businesses, that limitation doesn’t kick in until an individual owner’s taxable income exceeds $157,500, or $315,000 for a married individual who files a joint return.
Numerous rules and restrictions apply to the new QBI deduction, but it could provide significant tax savings for many independent contractors. The IRS is aware of this income-shifting strategy, and it’s expected to monitor worker classification closely while the QBI deduction is available.
Protect your business
Do you use independent contractors? Manufacturers who outsource work to independent contractors must work closely with tax and legal advisors to stay out of trouble with the IRS, state tax agencies and the DOL.