Employment Taxes and Worker Classifications, a five part series:
The Four Classifications of Workers and How They Are Taxed
In Part II of this blog series, we discussed a construction worker misclassification scheme in which three companies received hefty fines for registering their workers as member/owners of LLCs rather than employees. Although most workers are classified as employees or independent contractors, the IRS actually references four worker classifications for employment tax purposes: employee, independent contractor, statutory employee and statutory nonemployee. All workers – whether full or part-time, permanent or temporary - must be placed in one of these categories.
Employee status is preferred by most workers who seek the protections afforded by federal and state laws, and is ill-favored by businesses seeking to minimize expenses associated with employment taxes, employee benefits and protections.
Employers are obligated to remit the following taxes on behalf of their employees:
- Federal and state income taxes must be withheld from an employee’s pay and remitted periodically to the IRS and the state.
- FICA (social security and Medicare) taxes are split equally between the employer and the employee. Note that beginning January 1, 2013, employers must also withhold the 0.9% additional Medicare t ax from the employee’s pay.
- FUTA (federal and state unemployment taxes) are generally the employer’s sole responsibility.
Note that in some states, local taxes are paid by the employees (e.g., California state disability insurance).
At year-end, employers report the annual earnings of their employees on Form W-2.
Taxes are not withheld for independent contractors; self-employed individuals generally pay their own income and self-employment tax, which covers social security and Medicare. Neither they nor their employer pays unemployment tax and they are not eligible for unemployment benefits.
At year-end employers provide any independent contractor that was paid at least $600 during the tax year with a Form 1099-MISC. Income and deductions are reported on the independent contractor’s Schedule C.
Some workers who are independent contractors may still be treated as employees for FICA (and in some states FUTA) tax purposes. A statutory employee can be:
- a full-time traveling salesperson for a business who does not sell the goods to the general public and whose merchandise is sold for resale or for use in the buyer’s business operations;
- a driver who is an agent of a company or is paid on commission for delivering beverages (except milk), food products or dry cleaning;
- a full-time life insurance agent whose principal activity is selling for one life insurance company; or
- a person who works from home on merchandise for a specific employer, where the materials and specifications are supplied by that employer.
Although their employer must treat them as employees for social security tax purposes, with the exception of life insurance agents statutory employees do not receive employer benefits. Income tax is not withheld from the pay of statutory employees; they file their income and losses on Schedule C.
Under IRC §3508, licensed real estate agents and direct sellers who receive at least 90% of their income for sales or other output rather than number of hours worked are treated as independent contractors for federal tax purposes. Companion sitters also fall into this category.
Statutory nonemployees must be designated as such per a written contract. Income tax is not withheld from the pay of statutory nonemployees; they file their income and losses on Schedule C.
If a business is not prepared to hire permanent employees, a legal alternative is to hire temporary employees through a temp agency. Another option is to consider taking advantage of joint employment arrangements; for example, a company may outsource its payroll, benefits, training and/or other management tasks to a professional employer organization (PEO), which serves as the workers’ employer of record for tax and insurance purposes. (See Part IV of this blog series for information about the risks of third party services.)
Employment Classification Tax Defense
Moskowitz LLP is a full service tax firm of attorneys, certified public accountants, enrolled agents and numerous support staff. We have successfully defended businesses before the Internal Revenue Service, California Employment Development Department and the Department of Labors regarding employee classification disputes.