I’ll be sending out the W-2 and 1099s forms to my clients in the coming month, so it’s a good time to review the different types of employment classifications. One of the most frequently asked questions is if an employer should pay a worker as an employee or independent contractor.
According to the IRS, there are three categories to look at when determining worker classification: behavioral control; financial control; and relationship.
Behavioral control is when the employer has the right to direct or control the work performed. That means the more the employer can control behavior, like the type and degree of instructions and training, the more likely the worker is an employee.
Financial control is the employer’s right to direct or control the financial and business aspects. Examples are the employer providing equipment for use, giving guaranteed and regular wages, and reimbursing expenses. The more financial control, the more likely a worker is an employee.
Relationship is how the employer and worker perceive their interactions with each other. Was there a contract that describes the relationship? Does the employer provide benefits? Is the worker perceived as a key or important member of business?
There is no magic formula to determine employee vs. independent contractor—the key is to look at the entire relationship. If the employer has enough control over the worker, they are an employee. If the worker has autonomy, they are an independent contractor.
Right now, you may be asking: So, what?
If you misclassify an employee as an independent contractor, you would be liable for unpaid employment taxes for that worker. Unlike other liabilities, payroll taxes not only attach to the business, but also to the person responsible for remitting them. In other words, the employer (farmer) would personally be on the hook for them.
Now that I’ve scared you, how do you pay employees and independent contractors? Employees are paid wages, which are reported on a 943/W-2. There are two options for employers: Pay cash wages or commodity wages. The benefit to commodity wages is that the employer and employee are exempt from Social Security and Medicare tax. However, the employer must be sure to document the transfer of ownership of the commodity as well as follow other rules.
Independent contractors are paid with cash or commodities, and the employer reports it on a 1099 form. The independent contractor is responsible for paying the self-employment tax on their return. The employer has no fiduciary duty to collect and remit payroll tax; the responsibility is on the independent contractor.
Now is a good time to review employee classification. As previously stated, there isn’t a hard-and-fast rule to determine if the worker is an employee or independent contractor. I tell my clients to use the smell test: If both the employer and worker act and behave like there is an employment relationship, they are an employee. It’s better to go through a little extra work and file the 943/W-2 than potentially owe the IRS for failure to pay employment taxes. — Rod Mauszycki, DTN tax columnist
Tax Columnist Rod Mauszycki is a CPA and tax partner with the accounting firm of CliftonLarsonAllen, in Minneapolis, MN.