The self-employed are ordinarily classified as independent contractors for tax, workers’ compensation, unemployment and other purposes. “Independent contractor” is just another term for a person who does not have the legal status of an employee.
Whether you qualify as an employee or independent contractor is important both to you and the firms that hire you because an employer-employee relationship is very different from the relationship between a hiring firm and an independent contractor. Employees have a special legal status. Employers owe duties and responsibilities toward employees that do not exist when they hire independent contractors. Moreover, the tax treatment of employees is very different from that of independent contractors.
What happens if the IRS or other government agency determines that I’m really an employee, not an independent contractor?
Initially, it’s up to you and each hiring firm you deal with to decide whether you should be classified as an independent contractor or employee. But the decision about how you should be classified is subject to review by various government agencies, including the IRS and state workers’ compensation and unemployment compensation agencies. These agencies are constantly on the lookout for hiring firms that, in their view, misclassify employees as independent contractors. If one or more of these agencies determine that you should have been classified as an employee, both you and the hiring firm can suffer severe — but very different — consequences.
For example, if the IRS audits a hiring firm and determines that you should have been classified as an employee instead of an independent contractor, it will impose substantial assessments and penalties on the firm. At the very least, the firm will have to pay an amount equal to 20% of the FICA taxes that should have been withheld from your pay, 100% of the FICA and federal unemployment taxes the employer should have paid, a penalty equal to 1.5% of your compensation, interest and sometimes other hefty penalties as well.
No IRS penalties or assessments will be imposed on you. But you might lose certain business deductions because business expenses like home offices and health insurance premiums are not deductible for employees or the deductions are limited.
Audits by state workers’ compensation, unemployment compensation and tax agencies can also result in assessments and penalties being imposed on the hiring firm, but not on you.
Even though it is the employer — not you — who has to pay the penalties imposed by the government for misclassification, you can still suffer greatly if the IRS or other agency determines that a hiring firm should classify you as an employee. For one thing, the firm may dispense with your services because it doesn’t want to pay the additional expenses involved in treating you like an employee. Or, the hiring firm may insist on reducing your compensation to make up for the extra employee expenses.
How do government agencies determine whether a worker is an employee or an independent contractor?
There is no single, clear-cut test for classification. Different legal tests for determining worker status are used by various government agencies, including:
- the Internal Revenue Service
- state unemployment compensation insurance agencies
- state workers’ compensation insurance agencies
- state tax departments
- the United States Labor Department, and
- the National Labor Relations Board.
Each of these agencies is concerned with worker classification for different reasons, and has different biases and practices. Each agency normally makes classification decisions on its own and need not consider what other agencies have done, though they are often strongly influenced by them. As a result, it’s possible for one agency to find that a worker is an independent contractor and another that he or she is an employee. It’s also possible, though rare, for a worker to be deemed an independent contractor in one state and an employee in another.