When bringing on a new-hire, it is crucial that you as a business owner understand the difference between an employee and an independent contractor. The misclassifying of employees and independent contractors, or vice versa, is a red flag for federal and state tax authorities, and often results in an audit that can leave you, the business owner, accountable for an employee’s taxes that should have been withheld.
Whether a worker is an employee or independent contractor is determined by the common law; that is, court opinions defining who is an employee. The IRS uses a 20 factor test set forth in Internal Revenue Service (IRS) Revenue Ruling 87 – 41 to determine whether a worker is an employee. The IRS changed the 20 factor test referred to above to a three – category test analyzing various factors to determine whether a common law employment relationship exist between workers and a particular entity.
The categories are behavioral control, financial control and relationship of the parties. Each category contains types of information (facts) that illustrate the right to direct and control or its absence. These categories (behavioral control, financial control, and relationship of the parties) are controlling in determining an employer’s treatment and classification of his workers as employees or independent contractors. There are numerous fact finding questions to apply to each category. Make sure that you get professional advice when you are audited by federal or state tax authorities.
By understanding these differences and filing your workers’ taxes appropriately, you can avoid costly, time-consuming audits, and save your business from the difficulties inherent in dealing with the IRS.
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