The IRS and the Department of Labor closely watch how businesses classify workers. There are various penalties for paying someone as a subcontractor when they should be paid as an employee. A 1099-Misc should be used for a subcontractor, not for an employee. An employee should be paid in wages which means the employer must pay their share (1/2) of the Social Security and Medicare taxes (FICA), as well as pay into Unemployment Compensation and Workers Compensation.
Penalties for paying individuals incorrectly include
- a per W-2 penalty
- a penalty for not withholding federal tax and FICA tax from the employees pay
- a penalty for not paying employer taxes including FICA and unemployment
Also, if the IRS reclassifies a subcontractor as an employee, the employer will also owe the employee back benefits such as:
- sick pay
- retirement contributions
- medical & dental benefits
If the employer is found to have committed intentional misconduct or fraud they may owe penalties that include:
- 100% of BOTH the employee’s and employer’s FICA
- 20% of the amount that should have been paid as wages
- AND there is the possibility of criminal penalties as well
So if someone is an employee, it’s best to pay them that way. How do you decide? Well, there are lots of tests. There are three categories:
- Behavioral control
- Financial control
- Type of relationship of the parties
Some of the factors considered include……
- Is it possible that this person could have an overall loss for the year instead of a profit? Do they have actual business expenses or are they just getting income?
- Does this person invoice you?
- Are you the only person this person works for?
- Does this person use your tools and equipment?
- Does this personal follow your explicit instructions on how to do the job?
- Does this person market themselves to the public for the type of service they are providing to you?
- Do you have a written contract with them?
- Do you provide any employee benefits to this person?
- Is the work performed a key aspect of the business?
Here are some handy items from the IRS on worker classification:
There is a Voluntary Classification Settlement Program that may provide some relief. It is shown on the PowerPoint classification above.