This article is about the classification of a ‘worker’. As W-2s, 1099s, K-1s, and other tax documents make their way through the mail during this tax season, it’s a good time to think about the status of someone who is working for you or providing services to your business. Is that person an employee or not? And, why does it matter? When someone provides ‘work’ to a business it can come in different forms and under varying circumstances, and it’s important that a business define its working relationship with an individual early on in the relationship.
When a business hires an employee, it takes on substantial legal, tax, and other responsibilities under state and federal law. A business must pay and withhold a number of taxes from an employee’s paycheck, carry worker’s compensation coverage, and meet mandatory reporting obligations to the IRS and MN Revenue. The relationship between a business and its employee is also subject to multiple state and federal laws that address working conditions, pay, leave, anti-discrimination, and other issues. A person classified as an employee is entitled to the benefits the business offers to other employees.
In contrast, a business may hire an individual as an independent contractor to provide specific services or complete a project for the business. The relationship between a business and an independent contractor is not subject to the same state and federal laws that govern the employer-employer relationship, and, generally, a business is not obligated to collect and report withholding and other taxes. If a business pays the individual $600 or more, then generally only a 1099M is required.
Because the classification of a worker gives rise to very different levels of responsibilities and liability, it’s prudent for a business to define its relationship with a worker and avoid unintended consequences.
There are a number of ‘tests’ applied to determine whether a ‘worker’ is an employee or not. The IRS applies a 20-factor test. The courts have applied common law, an ‘economic realities’ test, and a combination of the two, and the U.S. Dept of Labor has set forth its own ‘economic realities’ test. Some important factors to consider are the control and direction on how the work will be performed, the financial investment related to the work, how integral the work is to the business, and the length of the relationship.
When applying the ‘economic realities’ test, a court or administrative body will consider how dependent the worker is on the relationship with the business from an economic standpoint. If an individual provides services to several businesses, purchases their own equipment, puts in place a contract with the business, and provides the services a temporary basis, then that individual may not be considered economically dependent on a single business. He or she would likely be classified as an independent contractor.
If an individual only provides work to one business, on a full-time basis, uses the businesses’ equipment and resources to do so, and gets to attend the company parties, then that person would more likely be classified as an employee.
There are exceptions to the application of this analysis and, generally speaking, for example, those providing professional services are classified as independent contractors, such as doctors, lawyers, and real estate agents. Also, member – owners of an LLC taxed as a partnership generally cannot be paid wages and classified as employee. Their earnings relating to the operation of the LLC pass through to their individual tax returns and reported on a K-1.
So, what should businesses do? What’s probably the single most important step in addressing this issue is for a business to set up different processes at the start of a working relationship with an individual. Employees should fill out applications, go through an interview process, fill out tax-related documentation, and get paid through payroll process. Independent contractors should provide a bid or estimate for the work to be provided, sign a services contract, provide an EIN, and get paid from an invoice and not through payroll.
In most cases it’s obvious who is an employee and who is not and especially when the business has followed procedures described above at the onset of the working relationship. For those cases when it’s not so obvious, it’s best to seek the advice of your attorney and tax advisor.
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