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 fringe benefits, and whether the employer should withhold income and/or employment taxes from the workers' pay. Any individual who works for another must belong to one of 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.
Employment taxes consist of FICA and FUTA taxes. The Federal Insurance Contributions Act (FICA) set up the Social Security and Medicare system to provide for retirement, disability, and hospital insurance for workers. Employment taxes are the employer's tax obligation in regards to employee compensation, including income tax withholding for federal, state, and local taxes, FICA taxes, and federal and state unemployment taxes. Some states also assess a disability tax.
There are 3 types of taxes that the employer must remit periodically to the federal government, based on employees' pay:
- ordinary income taxes withheld from the employee's pay
- FICA taxes: Social Security and Medicare taxes
- federal unemployment tax (FUTA).
Income taxes assessed on employees apply only to the employees, but must be withheld by the employer and remitted periodically. However, income tax is not withheld from the pay of statutory or nonstatutory employees. FICA taxes consist of 2 equal portions: an employer portion and an employee portion. The employee's portion of the employment tax must be withheld from the employee's pay and the entire employment tax, equal to 15.3% of the employee's pay, must be remitted to the tax collectors periodically. FUTA is assessed only on the employer. However, in some states, local taxes are paid only by the employees, such as Pennsylvania's unemployment tax and California's state disability insurance.
No taxes must be withheld for independent contractors, and different rules apply to statutory and nonstatutory employees. Hence, the taxes that must be withheld or paid by the employer depends on how the workers are classified.
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 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 classified by tax authorities as 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 tools, equipment, and materials to the employee;
- pays the employee by the hour, week, or month;
- pays the employee's business or travel expenses;
- has the 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.
If legally allowed, almost all businesses would hire their workers as independent contractors, since it saves on fringe benefits and the employer's share of payroll taxes. It also lessens their legal responsibility and their liability with respect to the worker. However, the tax code does not permit treating common-law employees as independent contractors, and the IRS prefers that the employer collect taxes from the worker, since it simplifies tax administration and increases tax collections. Therefore, the IRS also has a list of factors 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 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 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 classified as employees or independent contractors, which may be opposite to what the above characteristics would indicate. For instance, taxi drivers are frequently considered independent contractors, even though they typically use the company's equipment and operate under the license of the company.
Under the industry practice safe haven, a taxpayer can treat its workers as independent contractors if there is a long-standing recognized practice among significant members of the same industry. Here, an industry is a group of businesses catering to the same customers, selling the same products or services, in a given geographical or metropolitan area. Section 530(e)(2)(B) deems that 25%, not including the taxpayer, is considered a significant segment of the industry. Section 530(e)(2)(C) deems that 10 years is considered long-standing, although shorter periods may be adequate, depending on facts and circumstances, and the type of industry. Additionally, the taxpayer must have known about the long-standing practice, which may be supported by corporate minutes detailing the reasoning behind treating the workers as independent contractors.
The new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, allows pass-through entities, such as partnerships, limited liability companies, and S corporations, and sole proprietorship's and independent contractors to deduct 20% of their qualified business income. However, this deduction starts to phase out for couples earning at least $315,000.
Some workers, known as statutory employees, who are not common-law employees, are classified by statute (hence, the name) as employees for FICA tax withholding, and, in some states, for the FUTA tax, under IRC §3121(d)(3). Statutory employees otherwise work as independent contractors and file Schedule C to report their income and deductions. If they are not common-law employees, then the following workers are subject to FICA tax withholding, and, depending on state law, to FUTA tax:
- corporate officers who provide services to the corporation
- full-time life insurance agents working primarily for just 1 company
- delivery drivers of food, laundry, dry-cleaning, 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
Additionally, statutory employees, except for full-time life insurance salespeople, cannot receive employer benefits, including fringe benefits and retirement plans. However, statutory employees can set up their own retirement plans.
A statutory employee should receive Form W-2, with the Statutory Employee Box checked. 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. However, salespeople and homeworkers may be exempt from FICA withholding by the employer if they perform their services with their own equipment.
If you qualify as a statutory employee, then you can treat yourself as such. Recognition or acknowledgment of your statutory employee status by your employer is not necessary.
IRC §3508 defines another type of worker called a statutory nonemployee who is treated as an independent contractor. Statutory nonemployees are not treated as employees for FICA, FUTA, or federal income tax withholding. So, in essence, they are independent contractors in all respects, as long as they do not qualify as common-law employees, in which case, the statutory nonemployee provisions do not apply.
Statutory nonemployees include only 3 types of salespeople paid a commission or percentage of sales that composes at least 90% of their income, and that does not depend on the number of hours worked:
- licensed real estate agents
- 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, or of products for resale in the home; also includes the delivery of newspapers
- companion sitters
Like the statutory employee, statutory nonemployees report income and expenses on Schedule C, Profit or Loss from Business.
To be considered statutory nonemployees, qualified real estate agents and direct sellers must work pursuant to a written contract that the worker will not be treated as an employee for federal tax purposes. Only real estate agents who sell property can qualify as statutory nonemployees: the management of property is not a qualified activity. Companion sitters will not be considered employees of a companion sitting placement service if the company neither pays nor receives the wages of the sitter, but they may be considered an employee of the person for whom the services are rendered, depending on whether they satisfy the common-law employee criteria.
Temporary Workers and Professional Employer Organizations
A business owner has 2 other options for managing employee administration: temporary workers and professional employer organizations (PEOs). Temporary workers are usually provided by a temporary employment agency. Since the workers actually work for the temporary agency, it is the agency who provides and pays the workers, plus related costs, such as workers compensation. PEOs are similar except that the business owner hires or fires the employees, but the PEO handles the other aspects of employee administration, including paying payroll taxes, workers compensation, insurance for employees and unemployment insurance. They can also help the business owner to reduce the liability associated with employees.
Rev. Proc. 2022-13 allows a business to seek a review by the Tax Court by filing a petition with the court to challenge a worker reclassification by the IRS, if the IRS reclassified one or more individuals performing services for the business, during an audit of the business, as common-law employees rather than independent contractors. The IRS will issue a formal Notice of Employment Tax Determination Under IRC 7436, but the business does not need to wait until receiving this notice to seek a review by the Tax Court.