Errors in Job Placement: the Four Categories of Employment
Employers are faced with many challenges including determining what category the people they hire fall into. Workers are divided by the IRS into four categories: independent contractors, common-law employees, statutory employees, and statutory nonemployees.
Independent contractors are considered to be self-employed. People who work for a business that assigns jobs but gives them independence in carrying out the work are independent contractors. In contrast, common-law employees are subject to greater control by the employer; the business determines what and how tasks will be undertaken. Independent contractors have control over their methods and the means by which they complete an assignment while common-law employees are not able to take the same liberties.
Under common law rules, independent contractors may be treated as statutory employees for IRS purposes under certain conditions. If you hire a person that is a driver who distributes or delivers certain foods and beverages, is an agent, or is paid on commission; sells life insurance or annuity contracts for your company; works from home to produce goods based off of specific directions provided by your company; or is a salesperson selling goods for resale or use in the buyer's business operation, they may be considered a statutory employee. However, there are other stipulations that must be met. The worker must perform all services personally, lack an investment in the equipment and property used, and continually perform the services for the same employer. Lastly, a statutory nonemployee is a direct seller or real estate agent who is compensated based off of output and whose contract states they will not be treated as an employee.
How do you categorize your workers?
The IRS considers several factors when determining which category a worker falls into, including behavioral control, financial control, and the type of relationship. Behavior control refers to what extent the business controls how work is completed, financial control refers to what extent the business controls the financial aspects of the worker's job, and the type of relationship refers to how the relationship is seen by the workers and the business owner (are there written contracts or benefits?).
When you are determining if a worker is an employee, independent contractor, statutory employee, or statutory nonemployee, you must document the above factors used to determine your worker's categorization. The relationship is considered holistically; that is, instead of focusing on one specific factor, you should look at the entire relationship with the worker. If uncertainties arise, you or your workers can file a form with the IRS for official determination.
Why should you care about categorizing?
It is important to make the distinction between the different types of workers because they are treated differently by the IRS. For example, statutory nonemployees are considered self-employed for IRS purposes while common-law employees are not. In other words, different forms and taxes must be filed for different types of workers. Failure to properly do so can lead to penalties imposed by the Federal government. Thus, although determining which category a newly hired worker falls into may seem trivial, it is, nonetheless, very important financially.
The rules on categorizing a new hire can seem overwhelming, especially when you are trying to avoid penalties. Fortunately, Professional Employer Organizations (PEOs) specialize* in tax laws and how they pertain to independent contractors and employees. It can be beneficial to investigate PEOs so that you can save the time and hassle of research and paperwork.