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Employee or Contractor? The Taxing Distinction

As tax season is well underway, employers are asked to define who is on their payroll. Employees or contractors? This is a seemingly simple distinction, but an employer may not have the same classification as the IRS or their respective state's department of treasury. This label defines the obligations of both the employer and the worker to the IRS.

As many working adults know, contractors are self-employed and are responsible for paying Medicare and Social Security taxes. They are entitled to special tax deductions for business expenses. However, employees pay only half of these payroll taxes. Employers are required to cover the remaining half, and if the company is big enough, health insurance under the Affordable Care Act.

Jeffrey Saviano, the director of indirect tax at Ernst and Young predicts that there will be greater scrutiny by the IRS of this contractor/employee distinction. He stated "The stakes are higher for companies and the government because of the implementation of the (Affordable Care Act) and the employer mandate taking place in 2015." This mandate requires businesses with fifty or more full time employees to provide them with health insurance which meets certain criteria set out by the Act. In order to avoid this size based tax obligation, it would be very easy for a company of 100 to file their taxes stating they have 49 employees and 51 contractors. However it isn't so simple. The IRS frequently evaluates worker "misclassification" and has even set forth the SS-8 form to help individuals and companies classify their workers.

Classifying employees is a fact specific inquiry. In ruling a worker to be a contractor, the IRS analyzes whether workers have autonomy in creating their own schedule and if they decide the manner in which they perform their duties. Other factors include whether they provide their own equipment, and choose their own clients. Contrast this to employees who typically are provided workspace, have a steady flow of work and are generally paid benefits.

Additionally, states will often have their own set of criteria for classifying employees, which may be more stringent than the IRS. Jack Mozloom, a spokesman for the National Federation of Independent Business, advises that Connecticut, New Jersey, New York, California, Massachusetts, Oregon and Washington tend to have strict criteria for who may be classified as a contractor. Workers in states like these are more likely to be classified as employees.

Worker status may vary from state to state. Companies, looking to minimize payroll taxes and costs of benefits will often use out of state staffing agencies. However, even staffing companies must be mindful of how they classify their own employees. A contract labeling a worker a contractor will not persuade the IRS that he or she is a contractor. However, a contract clause stating another company may engage that worker's services may be of some value. If the IRS finds a company classified workers as contractors, when they should have been employees, harsh penalties may apply and they are calculated on the entire payroll, not just the misclassified employees. The IRS is more inclined to penalize a business, and not a worker for misclassification.

The Affordable Care Act's employer mandate has raised the stakes and heightened scrutiny over companies' classification of workers. Companies must ensure that workers are properly classified, or risk harsh IRS penalties.

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