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The IRS has publicly stated it plans to crack down on organizations that improperly classify workers as independent contractors instead of employees. Are you confident your employee classifications would stand up to IRS scrutiny?
Understand the Requirements
If a worker is an employee, your nonprofit must provide a Form W-2 annually and withhold income tax and the employee’s portion of Social Security and Medicare taxes from the employee’s pay. You also must pay the employer portion of Social Security, Medicare and unemployment taxes on the employee’s wages.
If a worker is an independent contractor, your organization generally should provide a Form 1099-MISC, which reports the amount you’ve paid to the person that year. The independent contractor is responsible for paying employment taxes (both the employee and employer portions) and income taxes on his or her own.
While the IRS generally should receive the same amount of total income and employment taxes regardless of whether someone is an employee or an independent contractor, the agency has found that it’s more difficult to collect from independent contractors. Thus, the IRS tends to favor employee status.
Should the IRS determine you’ve improperly classified an employee as an independent contractor, you may be held liable for that worker’s applicable employment taxes.
Take the Test
To determine whether a worker is an employee or an independent contractor, you must consider your nonprofit’s degree of control and the person’s level of independence. The IRS has assembled a number of questions to help employers decide. Commonly referred to as the “20-factor test” or “common law rule,” the questions revolve around:
- Whether your organization has the right to control the individual and how that person performs his or her duties (that is, behavioral control),
- Whether there’s a written contract between the individual and your nonprofit, and if the person receives employee benefits (that is, type of relationship), and
- Which aspects of the business relationship your organization controls (that is, financial control).
The IRS has suggested asking certain questions when determining status. For example, must a worker follow someone else’s instructions regarding when, where and how he or she completes work? If so, the person is probably an employee.
More examples: Employees are typically trained how to perform a given job, whereas independent contractors are expected to already know how to do it. Independent contractors must pay their own assistants. And someone who retains the ability to set his or her own daily hours (within reason) is generally regarded as an independent contractor.
Another factor to consider is whether the person works for more than one business at a time, which would indicate contractor status. Someone paid by the hour, week or month (rather than by the job), on the other hand, typically signals employee status.
Let the IRS Help
If you’re unsure whether an individual should be classified as an employee or an independent contractor, you can complete Form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding,” and the IRS will decide for you. The process is free, though it might take six months or more to receive the determination.
Organizations that inadvertently misclassify an employee as an independent contractor may be able to mitigate the consequences under the IRS’s Voluntary Classification Settlement Program. Ask your tax advisor for details.
Meeting the Challenge
The IRS has reported that it loses millions in unpaid taxes and uncollected penalties for misclassified workers each year — and is looking to get it back. Make sure your nonprofit is following the rules. For additional information on our small business advisory services, please contact Mike French, CPA, at 302.225.0600 or click here to email Mike. In a brief consultation he can assess your situation and determine the best way to proceed