The combination of a continuing tight labor market and a growing acceptance of and — in some cases — preference for gig work has translated to both large and small businesses hiring more freelancers and other independent contractors. These types of workers are paid what’s called non-employee compensation. Here’s what you need to know.
Non-Employee Compensation vs. Employee Compensation
Non-employee compensation includes fees, commissions, prizes, and awards. It’s treated differently than employee compensation for tax purposes.
For your actual employees, you generally must withhold and deposit payroll taxes — federal income taxes, Social Security and Medicare taxes, and unemployment taxes. You also may be required to withhold state income taxes.
The current tax rate for Social Security is 6.2 percent each for the employer and employee; for Medicare, the rate is 1.45 percent each. That means you must withhold 15.3 percent of employee compensation for these taxes.
Independent contractors are deemed self-employed individuals, though, so you needn’t withhold any taxes from their compensation. To make up for the employer portion of payroll taxes, they must pay self-employment taxes.
The tax treatment is just one of the reasons some businesses find independent contractors an appealing option. Hiring independent contractors also lets you off the hook for benefits like health insurance. And you can more efficiently scale your hiring, bringing on workers on an as-needed basis. All of this lets you increase your net business income.
Independent Contractor or Employee: The DOL and IRS Tests
If you misclassify an employee as an independent contractor, you can end up liable for back pay, taxes, and penalties, as well as potential court and attorneys’ fees if the situation leads to litigation. That’s why it makes sense to familiarize yourself with the criteria that determine a worker’s proper classification.
For federal purposes, there are two primary tests employers should understand, one from the U.S. Department of Labor (DOL) and the other from the Internal Revenue Service (IRS). Both largely focus on the amount of control you have over a worker.
The DOL test
The DOL test applies for purposes of the Fair Labor Standards Act, which provides minimum wage and overtime protections to employees — but not independent contractors. The test has been revised repeatedly in recent years, with different versions proposed and enacted, under Presidents Obama, Trump, and now Biden.
The current rule was originally proposed during the Trump administration and is generally regarded as more employer-friendly than the previous rule. The ultimate inquiry under the rule is whether, as a matter of “economic reality,” the worker is dependent on the employer for work (and therefore is an employee) or in business for himself (as an independent contractor).
The test consists of five distinct factors, and no single factor is determinative. By contrast, most courts and the DOL previously applied five or more overlapping factors.
The “core factors” are 1) the nature and degree of control over the work and 2) the worker’s opportunity for profit or loss. These are considered the most relevant and carry greater weight in the analysis. In other words, if these two core factors point toward the same classification, whether employee or independent contractor, it’s substantially likely that the classification is correct.
The rule also takes into account:
· The amount of skill required for the work,
· The degree of permanence of the working relationship between the worker and the employer, and
· Whether the work is part of an integrated unit of production.
According to the rule, it’s “highly unlikely” that these non-core factors can outweigh the combined weight of the two core factors. Basically, if the core factors both indicate that a worker is an independent contractor, the other three don’t really matter, even if all three suggest the worker is an employee.
Compared to the Obama-era test, the current rule considers the worker’s degree of investment and initiative only in the opportunity for profit or loss factor, and it excludes consideration of whether the work performed is central or important to the employer’s business. Overall, it’s a departure from court rulings, which generally apply the economic reality test as a totality-of-the-circumstances test — with no factor or factors having more weight.
In October 2022, though, the DOL proposed a new rule, which would rescind the current rule. The DOL says the new rule would bring back a totality-of-the circumstances analysis, with consideration of all factors. The so-called core factors wouldn’t be more important than any others. The rule would also restore consideration of whether the work is integral to the employer’s business.
Economic dependence remains the central focus under the new rule. It looks closely at whether the worker is in business for himself and makes clear that economic dependence doesn’t turn on the amount the worker earns or whether the worker has other sources of income.
Specifically, the proposed rule would evaluate:
1) The opportunity for profit or loss depending on managerial skill. Does the worker exercise managerial skill that affects the worker’s economic success or failure in performing the work? The decision to work more hours or take more jobs generally doesn’t reflect the exercise of managerial skill indicating independent contractor status under this factor.
2) Investments by the worker and employer. For a worker’s investment to indicate independent contractor status, the investment must be capital or entrepreneurial in nature (for example, rent or software), as opposed to just tools or supplies needed to perform the job.
3) The degree of permanence of the work relationship. An indefinite or continuous relationship is a sign of an employment relationship — but a worker’s lack of a permanent or indefinite relationship with an employer doesn’t necessarily mean they’re an independent contractor if it’s not due to the worker’s own independent business initiative. For example, seasonal or temporary work isn’t permanent, but that doesn’t mean no seasonal or temp worker is ever an employee.
4) The nature and degree of control. This factor looks at matters such as scheduling, supervision over the performance of the work, price-setting, and the worker’s ability to work for others. The DOL has emphasized that this factor wouldn’t take an “outsized” role in the analysis. It also notes that an employer’s compliance with legal obligations, safety or health standards, or requirements to meet contractual or quality control obligations could indicate the employer is exerting control over the worker.
5) The extent to which the work is an integral part of the employer’s business. The current rule rejects consideration of this factor. The proposed rule would examine whether the work is central to the employer’s business, not whether the worker possesses some unique qualities that make them indispensable as an individual. A worker who performs the work that an employer is in business to provide — but is just one of hundreds or thousands who do such work (for example, an operator at a call center) — is an integral part of the business even if that one worker makes a minimal contribution to the business overall.
6) The skill and initiative required for the work. Does the worker use specialized skills to perform the work? According to the DOL, this factor affirms the “longstanding principle” that the lack of specialized skills indicates employee status. So the proposed rule states that, where the worker brings specialized skills to the work relationship, it indicates that the worker is an independent contractor.
The comment period for the proposed rule closed on December 13, 2022, with more than 55,000 comments submitted, and the DOL is currently reviewing all timely submitted comments.
The IRS has identified three categories of factors that shed light on the degree of control — behavioral, financial, and type of relationship. There’s no “magic number” of factors that’s decisive — the IRS will weigh all of the relevant factors, as described below:
1) Behavioral: Does the employer have the right to direct and control the work that’s accomplished and how it’s done, whether through instructions, training, or other means? For example, if you provide a worker with detailed instructions or training on specific procedures, or focus performance evaluations on how work is performed, that indicates an employer-employee relationship.
2) Financial: Does the employer have the right to direct or control the financial and business aspects of the job? The IRS will want to know:
· Does the worker have unreimbursed business expenses?
· Has the worker invested in the facilities or tools used to do the work?
· Does the worker market their services to others?
· How is the worker paid? Flat fee or with a time-based wage?
· Does the worker have the ability to realize profit or loss?
3) Type of relationship between the employer and the worker: To determine the type of relationship, the IRS considers:
· Any written contracts or oral agreements that describe the intended relationship (note, though, that the labels in such agreements won’t decide the question if they’re different from the actual circumstances),
· Whether the worker receives benefits typical of an employment relationship (but the lack of benefits isn’t conclusive),
· The permanency of the relationship (indefinite or for a specific project or time period), and
· Whether the services provided are a key aspect of the employer’s regular business.
Note: States may have different — and more restrictive — tests than the federal tests. Check with the applicable state agencies.
Dealing with Misclassification
What if you think you may have misclassified an employee as an independent contractor? If you’re not certain, you can fill out and submit IRS Form SS-8 “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.”
Bear in mind, though, that the IRS is likely to conclude that an employment relationship exists, leading to potential liability for back taxes and more. You might want to use the form to just self-audit, without submitting it, or consult a CPA.
The IRS also offers a Voluntary Classification Settlement Program (VCSP) as a remedy for employers that have misclassified employees. It allows taxpayers to reclassify their workers as employees for future tax periods with partial relief from federal employment taxes.
To participate, the employer must meet certain eligibility requirements, apply to participate in the VCSP by filing IRS Form 8952, “Application for Voluntary Classification Settlement Program,” and enter into a closing agreement with the IRS. (You should, of course, get legal advice before signing on the dotted line.) Under a closing agreement, you will:
· Pay 10 percent of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year,
· Not be liable for any interest and penalties on the amount, and
· Not be subject to an employment tax audit of the worker classification of the reclassified workers for previous years.
Filing Form 1099-NEC
You’ll file different tax forms for independent contractors than you do for employees, for whom you file IRS Form W-2.
If you paid an independent contractor $600 or more in the tax year, you must file IRS Form 1099-NEC, “Nonemployee Compensation,” to report the total amount. This is a relatively new form, required since 2020. Previously, you would have filed IRS Form 1099-MISC, “Miscellaneous Income.”
You send copies to the worker (Copy B to file with their federal income tax return and Copy 2 to file with their state income tax return), the IRS (Copy A), and, if applicable, the state tax department (Copy 1). As the payer, you hold on to Copy C for your records. The due date to file Form 1099-NEC is on or before January 31, whether you’re using either paper or e-filing procedures.
You also need to be aware of some other tax forms when you use independent contractors. For example, the worker must complete IRS Form W-9, “Request for Taxpayer Identification Number and Certification,” so you have the necessary information for the Form 1099-NEC.
If a worker doesn’t provide a TIN, backup withholding rules apply so you must withhold 24% of all payments made to the worker and remit the amounts to the IRS. You must also file Form 1099-NEC for each person from whom you have withheld any federal income tax under the backup withholding rules, regardless of the amount of the payment.
If you aren’t e-filing your Forms 1099-NEC, you’re also required to file Form 1096, “Annual Summary and Transmittal of U.S. Information Returns,” by the same filing deadline for the forms themselves. Implementing tax software makes e-filing easier and lets you skip filing this form.
If you realize you’ve made an error on a Form 1099-NEC, you must issue a corrected form and, if applicable, Form 1096. If you file late or not at all, you could get dinged with penalties (from $50 up to $580 per form for 2023).
Gusto’s all-in-one payroll platform helps make it easy for you to outsource your projects to an independent contractor, regularly or occasionally. Learn more about it.