A worker’s employment status impacts the way that business pays them. The business must withhold income and Social Security taxes if a person is an employee. Independent contractors don’t have tax withheld from their earnings.
Getting the classification right is essential for both the workers and the business. The decision is often made by applying standard legal tests based on the real nature of the working relationship.
Taxes
Employees must file a tax return for the year they earned wages, whether a W-2 and 1099 workers. This information helps them claim any taxes they’re entitled to and determine if they must pay estimated taxes in the future. The information on a W-2 also allows an employee to claim any employment insurance benefits and federal income tax deductions.
Employers must also report on a Form W-2 all wages paid to an employee and the withholdings from those wages, including Social Security, Medicare and income tax withholdings. The top part of the form includes the employee’s name and address, which should match the information on their Social Security card. The bottom part of the W-2 reports federal and state withholdings and may include information for local taxation, too.
To properly classify a worker as an independent contractor or employee, employers must evaluate the relationship and consider all factors listed by the IRS in their rulings. A common rule of thumb is that if a company has the right to direct what, when, where and how a job is performed, it’s probably an employer/employee relationship.
If a business or worker can’t agree on their status, the IRS offers a questionnaire that can help determine the correct classification. A technician will review all of the facts and circumstances, seek additional input from the worker if necessary and issue a determination letter to the payer and the worker.
Tax Withholding
One of the reasons it’s important to be clear on employment status is that federal tax withholding varies based on whether you are an employee or a 1099 worker. Employees have the option to adjust their withholding on Form W-4 and can do so at any time of year if their circumstances change.
In contrast, independent contractors can’t adjust their withholding on a form; they’re liable for self-employment taxes (6.2% Social Security and 1.45% Medicare taxes) and income tax based on their estimated annual earnings. Many workers are surprised at tax time because they need more tax withheld throughout the year.
The best way to determine the right withholding amount is to fill out a W-4, which includes a tax withholding estimate based on marital status and number of dependents. A tax professional can help you complete the form correctly, if necessary.
In addition, it’s helpful to have copies of previous years’ tax returns available for reference. This allows you to reconstruct an accurate work history record, which is especially useful if your employer asks for a detailed employment history. If you need access to your prior tax records, the IRS provides a simple way to request transcripts of your previous tax filings, either online or by mail.
Payroll
Employees receive W-2 forms annually, detailing their annual compensation and payroll taxes withheld. Independent contractors, freelancers and other non-payroll professionals receive 1099s, which detail the total amount of money they earned from their clients in a year. Understanding the difference between these two categories of workers is essential to avoid misclassification, which can result in expensive penalties and back taxes.
A business should carefully consider each worker’s status before determining the type of tax form they need to fill out. Employees must be paid through the company’s payroll system and pay applicable federal, social security and Medicare taxes. The worker is most likely an independent contractor if the company pays the worker through other means, such as a cashier’s check or direct deposit.
The final deciding factor is the degree of control exerted over the worker. The worker is an employee if the company controls what, when, where and how the work is performed. Conversely, if the employer allows workers to complete the work at their convenience, they are most likely independent contractors.
If a worker’s employment status needs to be clarified after reviewing the three categories of factors, the IRS provides a special tool to help determine worker classification.
Tax Forms
The employment status an employer chooses for a worker significantly affects how a small business works with that person. It dictates the rights and employment protections a worker is entitled to, the taxes they must pay and whether a company must cover certain expenses for the worker, such as Social Security and Medicare contributions.
For these reasons, the IRS pays close attention to how firms classify workers. A firm should look carefully at the relationship and services provided to avoid an expensive mistake before determining employment status.
Suppose the firm is still determining a worker’s status. The firm or the worker can file this form.
Independent contractors must also file Form 1099-MISC to report annual earnings from several sources other than the wages they receive working for their employers. This includes income from rental properties, prizes and awards, and business income. The form is due by January 31. Self-employed people also must complete Schedule C to report the gross profit or loss from their businesses. The IRS has detailed instructions for both forms on its website.
