The U.S. Department of Labor (DOL) recently clarified classification of independent contractor status in a final rule that is scheduled to be effective March 8, 2021. The final rule reaffirms an economic reality test, which demonstrates whether individuals are in business for themselves or actually economically dependent on the business for work, by evaluating two core factors:
Three other factors may also provide clarity if the first two don’t point to the same classification:
It’s important to note that evaluating how the work will actually be done is more relevant than evaluating based on what is theoretically possible.
It’s important to get the classification right because the IRS has repeatedly put employers on notice: It's cracking down on organizations that improperly classify workers as independent contractors instead of employees. Are you confident that your employee classifications would stand up to IRS scrutiny?
Understand the Requirements
If a worker is an employee, your nonprofit organization must provide a Form W-2 annually and withhold income tax, the employee's portion of Social Security, and Medicare taxes from the employee's pay. You also must pay the employer portion of Social Security, Medicare and unemployment taxes on the employee's wages.
If a worker is an independent contractor, your organization generally should provide a Form 1099-NEC (this is a new requirement), which reports the amount you've paid to the person that year. The independent contractor is responsible for paying employment taxes (both the employee and employer portions) and income taxes on his or her own.
The IRS generally should receive the same amount of total income and employment taxes regardless of whether someone is an employee or an independent contractor. Should the IRS determine you've improperly classified an employee as an independent contractor, you may be held liable for that worker's applicable employment taxes.
Take the Test
To determine whether a worker is an employee or an independent contractor, consider your nonprofit's degree of control and the person's level of independence. The IRS has assembled a number of questions to help employers decide. For example:
If you answer "yes" to these questions, the worker is probably an employee.
More examples: Employees are typically trained to perform a given job, whereas independent contractors are expected to know how to do it. Independent contractors must pay their own assistants and may work for more than one business at a time. Someone who retains the ability to set his or her own daily hours (within reason) is generally regarded as an independent contractor.
Be Aware: Workers Can Go to the IRS
An employer can go to the IRS and ask for a determination on whether an individual is an employee or independent contractor. This is done by completing Form SS-8, "Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding." Note that workers can also file this form, which may call the IRS's attention to your nonprofit.
Filing an SS-8 is supposed to make it easy for employers to get a thumbs up or down on a worker's independent contractor status. But don't take this step lightly. By filling out a Form SS-8, and providing information about your relationship with workers, you may be inadvertently inviting the IRS to rule against you. This is an area where working with a tax advisor is highly advisable. Your tax advisor will be able to help you set up relationships with independent contractors that can stand up to IRS scrutiny.
If you inadvertently misclassify an employee as an independent contractor, you may be able to mitigate the consequences under the IRS's Voluntary Classification Settlement Program. Ask your tax advisor for more details.
Meeting the Challenge
The IRS loses millions of dollars a year in unpaid taxes and uncollected penalties for misclassified workers. Understandably, the government wants to collect this money. So make sure your nonprofit organization is compliant. More information on the final rule can be found on the DOL’s site.
For any questions related to this article or for human resources consulting in general, please contact Erin Young at email@example.com or 800.887.0437.