Tax Classifications For Workers: Employees, Independent Contractors, Statutory Employees, and Statutory Nonemployees

Tax law divides workers into specific classifications for employment tax purposes: employees, independent contractors, statutory employees, and statutory nonemployees. These classifications are used to determine the employer's responsibilities in regard to its workers, such as whether the workers are entitled to benefits, and whether the employer should deduct employment taxes, both payroll and income taxes, from the workers' pay. Any individual who works for another must belong to one these classifications. Improperly classifying the worker can have serious tax consequences, including hefty penalties and fees. All workers, whether full-time, part-time, or temporary, must be placed in one of these classifications.

Common Law Employees

Most workers will be categorized as either employees or independent contractors. The main distinguishing characteristic is whether the worker is independent and performs services for the general public, and whether the employer has control over the worker's methods and time. If the employer has the right to control the worker, then the worker would generally be an employee, even if the employer does not actually exercise control over the worker. The mere right to control is enough.

The IRS uses the following guidelines to determine whether workers are actually employees. The employer generally:

• determines when, where, and how the work is performed;
• trains the worker;
• sets the employee's hours;
• provides the employee with tools, equipment, and materials;
• pays the employee by the hour, week, or month;
• pays the employee's business or travel expenses;
• has a right to fire the worker at will.

The employee usually:

• renders his services personally and works mainly for the employer;
• has a continuing relationship with the employer;
• has the right to quit.

The work itself usually:

• is performed on the employer's premises;
• is an integral part of the business operation.

Independent Contractors

If they were legally allowed, almost all businesses would hire their workers as independent contractors, since it saves the business from supplying fringe benefits, paying business expenses, and paying the employer's share of the payroll taxes. It also lessens their legal responsibility and their liability with respect to the worker. However, the IRS prefers that the employer collect taxes from the worker, since it simplifies tax administration. Therefore, the IRS also has a list to determine whether the worker is actually an independent contractor. An independent contractor usually:

• hires, supervises, and pays for her own assistants;
• works on her own premises.
• is paid by the job or by commission, and has the risk of profit or loss.
• works for several customers at any given time, and provides her services to the general public.
• if under contract, then the independent contractor cannot be terminated at-will.

No one factor for the above listed characteristics of employees or independent contractors is determinative. Each factor must be considered in light of the whole. For instance, a janitorial service has no choice but to work on the employer's premises, because of the nature of the work. Hence, doing work on the employer's premises cannot distinguish a janitor who is an employee from one who is an independent contractor.

Many employers will also require that the worker sign a contract to affirm that they are, indeed, independent contractors. However, a contract cannot make an employee an independent contractor, since contractual terms cannot be enforced if they are illegal or against public policy. But the contract may be a consideration, where the classification is not clear.

Some industries regularly have workers that are classified as employees or independent contractors, which may be opposite to what the above characteristics would indicate. For instance, taxi drivers are frequently considered to be independent contractors, even though they typically use the company's equipment and operate under the license of the company.

Statutory Employees

Some workers, known as statutory employees, are automatically classified as employees by federal law, under IRC §3121(d)(3). This removes any ambiguity as to whether the worker should be treated as an employee or independent contractor, and includes the following workers:

• corporate officers who provide services to the corporation;
• full-time life insurance agents working primarily for just one company;
• delivery drivers of food, laundry, and similar products;
• full-time business-to-business salespeople, such as manufacturers' representatives and other traveling salespeople who do not sell directly to the public;
• homeworkers who were provided materials by a business to do piecework according to the business's specification.

Because the statutory employee is an employee by law, how they are paid is immaterial to their classification. Even statutory employees that are paid strictly commission are still defined as employees by law. Employers must issue W-2 forms to report the compensation paid. However, a statutory employee uses the same Schedule C, Profit or Loss from Business form that sole proprietors use to report their income and expenses.

Statutory Nonemployees

IRC §3508 defines another type of worker called a statutory nonemployee who is treated as an independent contractor. Statutory nonemployees include only 2 types of salespeople who are paid a commission or percentage of sales, and that does not depend on the number of hours worked: licensed real estate agents and direct sellers of consumer products to consumers, if the sales takes place outside of a retail store or showroom, such as door-to-door sales.

Like the statutory employee, statutory nonemployees report income and expenses on Schedule C, Profit or Loss from Business.