Employee? Independent Contractor? Or Neither?
Our firm was recently contacted by an individual (neither a sole proprietor, partner, member of an LLC nor Incorporation) asking if they have to add a cleaning person (who cleans their personal residence) to payroll and take out taxes or consider them as a contractor and send a 1099 at the end of the tax year.
This is where things get tricky. There is a clear line that separates employees from contractors when engaged in a business relationship. Since the individual is not involved in any type of business, payroll does not have to be run nor are they required to issue a 1099 at the end of the tax year.
The cleaning person on the other hand, is considered a small business/independent contractor and are therefore, legally obligated to report their income on their taxes.
The expenses paid for personal cleaning services are not deductible.
Businesses/Organizations would prefer to use independent contractors over employees as it saves them from paying required employment taxes. There is however, a clear line that differentiates between an employee and an independent contractor in the eyes of the IRS and this can be determined by following three simple tests:
Test #1: Behavioral - Does the business/organization control or have the right to control what the worker does and how the worker does his or her job?
As an example, a business office with a broken laptop would likely contact a computer repair shop to fix it. The business office has no idea how to repair the computer and would not dictate how the repair shop does their job. The repair shop would then be an independent contractor as they are in control of fixing the computer.
Conversely, if you hire a part-time administrative assistant the balance of control lies with the business/organization. The administrative assistant is instructed which business hours to work as well as given specific job responsibilities.
Test #2: Financial - If the payment aspect is controlled by the business/organization (i.e., amount to be paid, when payment will be made, if expenses are to be reimbursed, who is obligated to provide supplies required to do the job.)
In the previous example, the computer repair company would set the fee (whether hourly or per job, would be responsible if the job is underbid) and would have their own tools necessary to fix computers, again classifying them as independent contractors.
An administrative assistant, however, would be paid the salary agreed upon and would more than likely use the business/organization’s supplies and equipment and therefore, considered an employee.
Test #3: Relationship Type - Is there a hiring contract or employee benefits (such as medical insurance, pension plan, vacation/sick pay, etc.)? Will the work be performed on a continued basis?
Back to the example: When a computer repair company has completed fixing the computer, the business/organization will be invoiced with the agreed upon fee for payment.
Conversely, the administrative assistant would receive a paycheck for work performed and would continue working thereafter.
All-in-all the fines and penalties imposed by the IRS are quite steep if caught misclassing employees as independent contractors. It is far better to correctly categorize the relationship at the onset to avoid such penalties and frustrations.