The Tax Implications of Independent Contractors

Are your employees really employees, or are they actually independent contractors? It’s not just semantics; the IRS makes a stark distinction. You don’t generally have to withhold or pay any taxes on payments to independent contractors, as you do with employees. If you’re a business owner hiring or contracting with other individuals to provide services, consider the following:

• What degree of control and independence is there in the contractual arrangement? Does your company control or have the right to control what the worker does and how the worker does his or her job?
• Do you control the business aspects of the worker’s job? This includes considerations like how the worker is paid, whether expenses are reimbursed and who provides tools and supplies.
• Are there written contracts or employee benefits such as a pension plan and vacation pay, and will the relationship continue? Is the work performed a key aspect of the business?

You need to weigh all factors when determining whether a worker is an independent contractor. The key is to look at your entire relationship and decide the degree or extent of your right to direct and control how he or she works. Document each factor used in coming up with your determination.

For an official ruling, you can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS. The agency will then review the facts and circumstances and officially determine the worker’s status. It can take up to six months to get an answer, but at least you’ll feel confident in the determination.

Unsure of status?

If you’re sure the workers in question are independent contractors, have them complete Form W-9, Request for Taxpayer Identification Number and Certification. Keep the W-9 in your files for four years for future reference in case any questions arise. Do not have them submit Form W-4, which is only for employees.

Next, use Form 1099-NEC, Nonemployee Compensation, to report payments of nonemployee compensation. (Form 1099-NEC recently replaced Form 1099-MISC for the payment of independent contractors.) A copy of 1099-NEC must be provided to the independent contractor by Jan. 31 of the year following payment. If you paid more than $600 in a calendar year to a nonemployee, use 1099-NEC to report payments. Send a copy of this form to the IRS as well.

You can file these forms electronically. The Filing Information Returns Electronically, or FIRE, system is set up for financial institutions and others to file information returns. You need software that produces the file in the proper format as required by Publication 1220. FIRE doesn’t provide an electronic fill-in form option.

Working with independent contractors offers flexibility, because you don’t have to set up a new department to get the task done. Contracting doesn’t involve the scads of paperwork that go with hiring an employee, either. And there are fewer payments to the IRS, as you don’t have to match payments of taxes such as Social Security tax or pay unemployment tax. Just make sure not to misclassify an employee as an independent contractor to avoid federal fines and penalties.