For most small businesses, including sole proprietorships, household employers, and C corporations, business taxes for the 2021 tax year are due April 18, 2022. For S corporations and partnerships, taxes are due March 15, 2022. That means it’s time to get organized. One of the things small business owners need to do before filing payroll taxes is identify the status of each of their workers as contractors or employees.
How to determine if your worker is an employee or independent contractor for payroll tax purposes
For payroll tax purposes, the difference between classifying a worker as an independent contractor or employee is whether the business is responsible for withholding and paying payroll taxes out of a worker’s wages or salary. Independent contractors are responsible for paying 100% of their own payroll taxes while employers split the cost of these taxes.
According to irs.gov, the current tax rate for social security is 6.2% for the employer and 6.2% for the employee, which equals 12.4% total. The current rate for Medicare is 1.45% for the employer and 1.45% for the employee, which equals 2.9% total. Together, employers pay 7.65% in payroll taxes for each employee and they must withhold the employee’s share from their paycheck.
A worker’s classification is mostly based on whether the employer directs or controls how the worker completes their work. If your business retains the legal right to control a worker’s activities, that worker would likely be considered a common-law employee for tax purposes.
IRS analysis of worker status
When IRS auditors analyze whether a worker is an employee or independent contractor, they now focus on three categories before deciding if the employer has enough control over the worker to create an employer-employee relationship. Other factors will be considered, including the type of work being done and the circumstances of your particular case.
The IRS gathers evidence about worker status by assessing criteria in the following three categories:
1. Behavioral (control over how the worker performs their work)
2. Financial (control over the financial aspects of a worker’s activities such as expenses)
3. Type of relationship (does the worker receive benefits? do they have an ongoing contract?)
Up until the recent past, auditors used a list of 20 questions to determine worker status in an audit. The concepts behind the questions are still valid and worth understanding.
1. Is the worker required to follow your instructions on when, where, and how they work? If so, they are more likely to be an employee.
2. How much training did you provide the worker? Independent contractors are supposed to know how to do their work without training.
3. How closely are the worker’s services integrated into your business’s success or continuation? If they are closely tied then the worker is more likely to be an employee.
4. Do you require the worker to personally perform the services you hired them for? If so, they are more likely to be an employee.
5. Does your worker have an in-house assistant they are not in charge of hiring, supervising, or paying? If so, they are more likely to be an employee.
6. Do you have an ongoing relationship with the worker for significant periods of time or at recurring intervals? If so, they are more likely to be an employee.
7. Do you set hours of work? If so, they are more likely to be an employee.
8. Do you require the worker to work for your firm full-time? If so, they are more likely to be an employee.
9. Do you require the worker to complete their work at your office or any specific place? If so, they are more likely to be an employee.
10. Do you set the order or sequence in which they complete their work for you? If so, they are more likely to be an employee.
11. If you require your worker to submit regular reports, they are more likely to be an employee.
12. If you are paying your worker by the hour, week, or month rather than by the job, they are more likely to be an employee.
13. If you pay the worker’s expenses then they are more likely to be an employee.
14. If your worker uses tools, materials, and other equipment supplied by your company, they are more likely to be an employee.
15. Has your worker made a large investment in their own facilities and equipment that they use to complete their work? The bigger their investment the more likely that they are an independent contractor.
16. If your worker is taking on a sizable risk of profit or loss in turning in their services, they are more likely to be independent contractors.
17. If your worker works for more than one business at a time, they are more likely to be an independent contractor.
18. Workers who advertise their own services to the general public are more likely to be an independent contractor.
19. Workers who you have the right to fire at any time are more likely employees. By contrast, independent contractors can’t usually be fired unless they break certain contractual terms.
20. Workers who have the right to quit at any time without incurring any liability to you are more likely employees. Contractors can’t usually walk away without completing the project they were hired to do.
Safe haven for proper classification of workers
The tax law does provide a safe haven rule that allows employers a reasonable degree of protection from penalties for misclassifying a worker if their worker was:
- hired after 1977,
- never treated as a common-law employee,
- you, the employer, have filed all required federal tax returns, including information returns (Forms 1099-MISC),
- and if you had a reasonable basis for not treating the individual as an employee.
Note: Employers cannot get out of their obligations as an employer by having an employee sign a contract that they are a contract worker. If your interactions with the worker meet the criteria for an employer-employee relationship, then your workers are legally employees regardless of how you choose to describe them.
If you are still unsure about whether your worker is an employee or contract worker, speak to a tax professional. This is the safest way to avoid receiving a bill for unpaid payroll taxes because of a misclassified worker. If you truly cannot determine the right designation or you are questioning an assessment made by a tax auditor, know that there is a way to request a worker classification ruling from the IRS.
Partnering with Makai HR
Need help with payroll and other HR services? We’ve got you covered through HR outsourcing! When you partner with Makai HR you can get on with the business you are trying to grow while we take care of your employee needs from payroll to taxes, health insurance/benefits and worker’s compensation. You also gain peace of mind that you are compliant with all of Hawaii’s employer laws (if you’ve ever looked you know that the list is very long and changes happen). When choosing a PEO to partner with, there are many things to consider including cost, services, and technology solutions.
With the cost of doing business in Hawaii at record highs, we know how important it is to keep labor costs in line with revenue. Our plans are priced competitively and include value-added services like time-in/time-out systems. Our three tiers of PEO service plans are tailored to the size of your business and specific needs. We offer a 100% paperless solution which means that your employees can manage their needs through a computer, tablet, or phone. We can truly improve your employees’ work benefits while freeing you up to run your business.
What are you waiting for? Companies that partner with a PEO benefit from 7-9% faster growth, 10-14% lower employee turnover; and they are 50% less likely to go out of business. Contact us today to get started!