To determine whether a worker is an employee or independent contractor in the eyes of the IRS, you must go through the following four steps:
- Step One: Check to see if the worker is a statutory independent contractor—that is, someone who is an IC simply because the law says so. Three categories of workers can be statutory ICs: direct sellers, licensed real estate agents and companion sitters. If the worker is not a statutory independent contractor, go on to Step Two. If the worker is a statutory IC, do not proceed to Step Two. You can treat the worker as an IC, and you don’t have to pay or withhold federal payroll taxes.
- Step Two: Apply the IRS common law test to determine whether the worker is an IC or employee. If you are certain the worker should be classified as an IC under these rules, proceed to Step Three. If you think the worker should be classified as an employee under the common law test, go to Step Four.
- Step Three: Check to see if the worker is a statutory employee. If the worker is not a statutory employee, and you determined that the worker could be classified as an independent contractor in Step Two, then you can stop. The worker is an IC, and you don’t have to pay federal payroll taxes. If the worker is a statutory employee, go on to Step Four.
- Step Four: If you think the worker should be classified as an employee under the common law test or if the worker is a statutory employee, check to see if the worker fits into the Safe Harbor rules. If so, you can treat the worker as an independent contractor. You don’t have to pay or withhold federal payroll taxes. If the worker does not fit into the Safe Harbor rules, then the worker is an employee and you must pay federal payroll taxes.
Caution This Discussion Applies Only to Federal Payroll Taxes
In this article, we are only examining whether the employee is an IC for purposes of federal payroll taxes. Once you’ve come to a conclusion in this arena, your job is only half done. You must still determine whether the worker is an IC for purposes of state payroll taxes, unemployment insurance and workers’ compensation insurance. We discuss these issues in more detail in later articles.
Although the IRS is in charge of collecting federal payroll taxes, it’s up to you to make the initial decision as to whether you must withhold and pay such taxes for workers. That is, you must look at each of your workers and decide who is an employee and who is an independent contractor and then pay your federal taxes accordingly.
Eventually, the IRS, may review and audit your classifications. The IRS takes this enforcement task very seriously. If it determines that you wrongly classified workers as ICs, it will impose charges and penalties.