Business Relationships for Tax Purposes

Primarily for Tax purposes, a business owner must correctly determine whether individuals providing services are employees or independent contractors. If you are a business owner, you will want to review this information to determine whether individuals you hire are independent contractors or employees.

Generally, a business owner must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee, but does not have to withhold or pay any taxes on payments to independent contractors.

Before a business owner can determine how to treat payments for services, the business relationship that exists between the owner and the person performing the services must first be established. The person performing the services may be:

An independent contractor
An employee (common-law employee)
A statutory employee
A statutory nonemployee

In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.

Independent Contractor (Self Employed)

People such as lawyers, contractors, subcontractors 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.

The general rule is that an individual is an independent contractor if the person for whom the services are performed, have the right to control or direct only the result of the work and not the means and methods of accomplishing the result.
Example: An independent driver delivers medicine to certain medical facilities for a major business concern. The driver uses his own vehicle and is paid for the delivery, not the time or method to make the delivery. The driver also performs additional deliveries under contracts with other companies that he obtained through advertisements. The driver is an independent contractor.

FORM W-9If the determination has been made that the person to be paid for providing services is an independent contractor, the business owner must request that the contractor complete Form W-9, (Request for Taxpayer Identification Number and Certification).

This form can be used to request the correct name and Taxpayer Identification Number or TIN, of the worker. A TIN may be either a Social Security Number (SSN), or an Employer Identification Number (EIN).

The W-9 should be kept in the business owner’s files for four years for future reference in case of any questions from the worker or the IRS.

Independent Contractors generally receive a Form 1099-MISC at the end of the year reporting earned income and any tax withheld.

Employee (Common-Law Employee)
Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is true even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.

Common Law Rules
Facts that provide evidence of the degree of control and independence fall into three categories:

Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?

Financial: Are the business aspects of the worker’s job controlled by the payer? (These include things like how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)

Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control.

Employees will generally receive a Form W-2 at the end of the year reporting their earnings and tax withholdings.

Statutory Employees

If workers are independent contractors under the common law rules, such workers may nevertheless be treated as employees by statute (statutory employees) for certain employment tax purposes if they fall within any one of the following four categories and meet the three conditions described under Social Security and Medicare taxes, below.

A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.

A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.

An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done.

A full-time traveling or city salesperson that works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer’s business operation. The work performed for you must be the salesperson's principal business activity.

AND...
Social Security and Medicare taxes must be withheld from the wages of statutory employees if all three of the following conditions apply.

The service contract states or implies that substantially all the services are to be performed personally by them.

They do not have a substantial investment in the equipment and property used to perform the services (other than an investment in transportation facilities).

The services are performed on a continuing basis for the same payer.

If, after reviewing the three categories of evidence, it is still unclear whether a worker is an employee or an independent contractor, Form SS-8, Determination of Worker Status for Purpose of Federal Employment Taxes and Income Tax Withholding can be filed with the IRS. The form may be filed by either the business or the worker. The IRS will review the facts and circumstances and officially determine the worker’s status.

Statutory employees generally receive a Form W-2 at the end of the year with box 13 checked indicating Statutory status.

Statutory Nonemployees

There are generally two categories of statutory nonemployees: Direct Sellers and Licensed Real Estate Agents. They are treated as self-employed for all Federal tax purposes, including income and employment taxes, if:

Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked, and

Their services are performed under a written contract providing that they will not be treated as employees for Federal tax purposes.

Form 1099-MISC is most commonly used by payers to report payments made in the course of a trade or business to others for services. If you paid someone who is not your employee, such as a subcontractor, attorney or accountant $600 or more for services provided during the year, a Form 1099-MISC needs to be completed, and a copy of it must be provided to the independent contractor by January 31of the year following payment. The business owner must also send a copy of this form to the IRS by February 28.Independent contractors may have their own employees or may hire other independent contractors (subcontractors). In either case, they should be aware of their tax responsibilities, including filing and reporting requirements, for these workers