Independent contractors are U.S. taxpayers who work for themselves rather than as employees of a company. From the perspective of the Internal Revenue Service (IRS), the main difference between independent contractors and employees is that independent contractors do not have their income tax withheld from their earnings, including payments for FICA (Social Security and Medicare) tax. Therefore, it is the responsibility of the contractor to calculate and pay these taxes, often in the form of quarterly tax payments throughout each year, as well as keeping track of all earnings.
It is not difficult to establish yourself—or someone with whom you contract—as an independent contractor with the IRS, but there are several things you should be aware of to understand the basic process and the differences between contractor and employee statuses. If you have any questions, you can learn more from the IRS or a qualified tax advisor.
1. Independent Contractor Status Is the Exception, Not the Rule
The IRS assumes that a taxpayer is an employee unless it is proved otherwise. The burden of proof is on the taxpayer, not the IRS, to prove independent contractor status.
2. The Irs Looks at Three Major Factors in Determining Worker Status
- Financial control: Are the business aspects of the worker's job controlled by the worker? These include things like how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies for the work.
- Behavioral control: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Nature of the relationship: Are there written contracts or employee-type benefits (e.g., pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Usually, no one factor is determining of status; the IRS looks at the entirety of the factors.
3. New-Hire Paperwork for Independent Contractors Is Simple
Only three new-hire documents are needed for a business to work with an independent contractor; these should be kept in a file for the contract worker, in case of audit:
- Form W-9, to provide a taxpayer identification number (If a business has a valid taxpayer ID number for a contractor, it does not have to withhold federal income taxes from payments to the contractor. If it does not have a valid taxpayer ID number, it must withhold federal income taxes. This is called backup withholding.)
- A copy of the independent contractor's resume or professional qualifications
- A copy of the work contract
4. Paying an Independent Contractor Is Also Simple
A business can pay a contractor by the hour or by the job, however, the two parties agree. In most situations, no income tax or FICA taxes are withheld and no other employment taxes must be paid based on independent contractor pay. This is assuming the business (payer) has a tax ID number for the contractor (payee).
5. Contractor Pay Is Reported Annually on Form 1099-Misc
IRS Form 1099-MISC for reporting contractor pay reporting is similar to Form W-2 for employee pay reporting. A 1099-MISC form must be given to the contractor by the end of January (for the preceding tax year) and submitted to the Social Security Administration by the end of February.
6. Independent Contractors Must Pay Self-Employment Taxes
Independent contractors are not employees, and the companies or clients they work for do not withhold FICA taxes from their pay. Therefore, independent contractors must pay self-employment tax based on their total income from self-employment each year.
7. Independent Contractors Can Be Any Business Legal Type
Most independent contractors are set up as sole proprietors. Alternatively, they can be set up as a limited liability corporation (LLC), partnership, or corporation. Depending on the type of work done by the contractor, it often makes sense for contractors to form a business type that limits their personal liability.
8. Relief Requirements Allow Continued Pay for Independent Contractors
If a business has been paying someone as an independent contractor and can show good reason for doing so (because of industry practice or other reasons recognized by the IRS), it may be able to continue to pay the worker for an extended period as an independent contractor rather than as an employee. The rules for these payments are outlined in the relief requirements, under Section 530 of the Internal Revenue Code.
9. Agreements Help Clarify Expectations for Independent Contractors
Even in the most casual situations, it's a good idea to create a contract for all paid work with an independent contractor. The IRS does not look at the contract as "proof" that the worker is a contractor, but it helps both the business and the contractor understand expectations and the nature of the relationship.
10. The IRS Can Verify Independent Contractor Status
You can ask the IRS to give you a determination letter to clarify independent contractor status. Use IRS Form SS-8 to request a determination. You provide the information requested on the form and the IRS sends you a letter giving their opinion on the status of this worker (employee or independent contractor).