For tax purposes classification matters
The Internal Revenue Service has laid down specific guidelines that explain how to distinguish between an employee and an independent contractor. At times, these guidelines still do cause some consternation, for both employers and for employees.
While some will tell you that the "terms" employee and employer do not necessarily govern the relationship, you should consider having your contracts reviewed by a tax accountant or lawyer before sending them to your freelance clients. Why run the risk?
The Internal Revenue Service website states the following ruling: "Independent Contractor: The general rule is that an individual is an independent contractor if (the person for whom the services are performed) has the right to control or direct only the result of the work, and not what will be done and how it will be done or method of accomplishing the result."
"People such as lawyers, contractors, subcontractors, public stenographers, and auctioneers who follow an independent trade, business, or profession in which they offer their services to the public, are generally not employees. However, whether such people are employees or independent contractors depends on the facts in each case."
Here are some steps you can take to distinguish whether you will be considered an employee or an independent contractor.
Who controls the work being done?
- Employee: If the employer controls the work that is being done (e.g. how it is done and what is done) then you are considered an employee.
- Independent contractor: If your client tells you what must the end result is but does not instruct you as to how to get to that end result, you may be considered an independent contractor.
Who supplies the equipment?
- Employee: If the tools that you require to complete the job are supplied by a business, then chances are that you will be considered an employee.
- Independent contractor: If you are responsible for having (or obtaining) the equipment or tools that you need to complete an assignment then you may be considered an independent contractor.
While your written contract may clarify the proper terms (e.g. employee or independent contractor) the Internal Revenue Service does not have to "honor" the contractual language. Generally speaking the IRS will make a determination based on the entire relationship between the two parties in deciding if the relationship is one of an employer/employee or business/independent contractor.
Nature of relationship issues
The nature of a relationship can also impact how the Internal Revenue Service believes that your work should be classified. Here are some "key" factors in making that determination:
- Length of time of contract - if you are going to be working over an indefinite period of time with a single business your relationship may be classified as that of an employer/employee.
- Business importance - if the work that you are doing for a business is critical to the long term standing of that business, you may be considered an employee rather than an independent contractor.
While these are only a couple of the factors that can influence how your relationship is classified, there may be others that will be taken into consideration.
Self protection in all cases
The Commonwealth of Massachusetts has a different set of rules that apply to independent contractors. For example, companies like H & R Block who hire temporary employees to get them through tax season may no longer consider these people independent contractors. Since these types of laws may exist in other states, it is imperative you verify your own state laws.
It is a good idea to have all contracts for independent work reviewed by a tax professional to ensure that you are not being misclassified. If you have been classified as an independent contractor and believe that you should be classified as an employee, you may be able to request a review of your status through the IRS.
How to prepare a 1099 for a contract worker
The Internal Revenue Service (IRS) requires that those who hire freelance contractors are required to report all payments made to contractors on an annual basis. Each contractor's earnings must be reported if they exceed $400. The IRS has made filing simple for those who use electronic filing or they may be filed by mail.
1099 forms are due to the taxpayer (contractor) not later than the first day of February following the tax year ended December 31. They are due to the IRS not later than the last day of February if paper filing and not later than April 12 if electronic filing is used. The IRS uses this information to guarantee that contractors are filing proper earnings on their taxes as well as verifying employment eligibility. 1099 forms are required only for US contractors.
Simple preparation of 1099 forms
Step 1 Payer’s information
The first block to be filled out on a 1099 form is the information about the person (or company) making payments. This includes the name, street address, city, state and zip code. This information goes in the upper left hand block of the 1099 form.
Step 2 IRS form 1099 block 3
For contractor payments, the payee must include the amount paid to the contractor in box number three (Miscellaneous payments). The full amount paid must be put into this box including any deductions that were made.
Step 3 Taxpayer identification numbers
Underneath the payer's box, the payee's taxpayer identification number as well as the recipient's taxpayer identification number must be included.
Step 4 Recipient information
There are separate blocks that must be filled out to complete the recipient's information. The blocks are (a) Name (b) street address (c) city, state, zip code.
Step 5 Withholding information
If any amounts were withheld from payments they should be noted in the appropriate boxes. These include:
- Box 4 - Federal tax withholding
- Box 6 - Medical or health care payments
- Box 16 - State tax withheld (if this box is populated 17 and 18 must be filled out)
Step 6 Mailing copies
Copies must be sent to the recipient as well as to the Internal Revenue Service office.