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Tax implications of classifying employees vs. contractors

On Behalf of | Jun 25, 2019 | Firm News |

Companies like Uber and Lyft have recently made news for misclassifying drivers as independent contractors rather than employees. Understanding such classifications can be especially critical for small businesses.

According to The Balance, classifying workers as employees or contractors alters how you pay the workers, how they pay taxes and how your business pays taxes. New York business owners must correctly classify workers to determine whether to withhold income taxes, pay FICA taxes, or Social Security and Medicare taxes, and pay unemployment tax. Misclassifying can lead to significant penalties from the IRS.

Employee vs. contractor: The main differences

The IRS states that generally, a worker is an independent contractor if your business maintains the rights to only control the results of their work. When a worker is an independent contractor, your business is relieved of the obligation to pay FICA taxes. The contractor must also pay their own income taxes.

Understanding the three categories to determine status

When the general rule still seems vague, the IRS advises analyzing the following three categories to determine whether a worker is an employee or independent contractor:

  • Behavioral control. Does your business have the right to control the work completed by the worker? Businesses typically train and direct employees, while contractors control both their working hours and how they complete work.
  • Financial control. Consider the financial and business aspects of the worker’s role. Contractors typically provide services valuable to other businesses, receive pay based on a flat fee and do not receive reimbursement for expenses.
  • Type of relationship. Lastly, consider your relationship. Employees typically receive benefits and enjoy employment without a specified end date, while your business may require contractors on a more temporary basis.

Typically, a written contract indicates whether the worker is an employee or contractor. Because the IRS generally assumes all workers are employees, you must assert if a worker is instead an independent contractor.

When the classification is incorrect

Regardless of your good intentions, mistakes can occur that result in the misclassification of a worker. When your business misclassifies an employee as a contractor, you may face penalties for seemingly sidestepping paying taxes on the worker. The IRS may order you to pay back-taxes as well as other penalties. To prevent such errors, consult with the IRS’s guidelines and work with a tax professional.