The distinction has significant implications for both the employer and the employee. Employers prefer to treat individuals as independent contractors, because they avoid having to match the employees’ payroll tax, pay benefits, pay unemployment insurance, etc. This results in a significant savings for employers.
When you are an employee, the employer pays you a net amount after making all the required tax withholdings. The employer provides you with a W-2 for tax reporting that shows your taxable wages and details all of the withholding amounts. If you are an independent contractor, the employer will pay you a gross amount without any withholding, and will issue you a 1099-MISC.
Independent contractors must pay self-employment (SE) tax instead of having FICA (Social Security and Medicare program contributions) deducted from their wages. The SE tax rate is generally twice the amount of the FICA rate. Independent contractors are generally treated the same as self-employed individuals; therefore, the SE tax and income tax are based on their net earnings after deducting any allowable expenses incurred to earn the income.
The problem in this scenario is that employees generally do not have tax-deductible expenses related to their jobs. Employees who are incorrectly classified as independent contractors find themselves essentially paying both the employer’s and their own share of the Social Security and Medicare taxes. To make matters worse, as an independent contractor, no federal or state income tax was withheld, leaving the independent contractor with a sometimes unexpected tax liability.
Classifying a worker as an employee or independent contractor is not discretionary for the employer. The employer must follow federal guidelines when making the determination. Basically, it boils down to whether the employer has direction and control over the individual, which includes, among other guidelines, specifying working hours, how to perform the work tasks, the right to fire, etc. If the employer has direction and control, the individual is probably an employee.
If you have been treated as an independent contractor and think that you are really an employee, you do have recourse. You can file Form 8919. If the IRS agrees with you, you only have to pay the employee share of FICA/Medicare not the self-employment tax. You must, however, pay the income tax. The filing will make life miserable for your presumably former “employer,” so it might be a bridge-burning exercise.
If you are an employer or employee and have questions, contact your Tax Consultant. Your Tax Consultant can explore alternatives, as well as provide assistance filing Form 8919, if needed.