When bringing back workers, follow the rules
Part of your nonprofit’s entrance into the “new normal” nonprofit world may involve rehiring workers — and perhaps hiring some new replacements. For tax obligation purposes, you’ll be required to classify those workers as employees or independent contractors (ICs).
Sizing up IC benefits
Treating a worker as an independent contractor (IC) rather than an employee can provide an organization with important advantages. For example, there’s no need to withhold federal income and FICA (Social Security and Medicare) taxes, pay the employer’s share of FICA or have state unemployment tax obligations.
You also may avoid certain other state obligations, such as income tax withholding, unemployment, workers’ compensation and disability insurance (if your state requires it). Plus, you won’t have to provide ICs with employee benefits, minimum wages or overtime pay.
But simply labeling someone an IC doesn’t make it so. Whether a worker is properly classified as an IC or employee depends on several factors targeting the level of control you exert over that individual.
Tax authority’s point of view
There’s a common misconception that the IRS and state tax agencies aren’t concerned about worker classification, as long as you provide ICs with Forms 1099 and satisfy the reporting requirements. But tax authorities prefer employees over ICs for several reasons, including the following:
- Employers are less likely to default on tax obligations.
- Employers remit income and payroll taxes more quickly (usually monthly), whereas ICs make quarterly estimated tax payments.
- It’s easier to audit, and collect from, a single employer rather than multiple ICs.
In general, tax authorities collect more from employees than from ICs, who’re permitted to deduct various business expenses.
What the IRS scrutinizes
The IRS will examine whether you have the right to direct or control how an individual performs his or her work — not whether you actually do so. Providing detailed instructions to the worker, training on the organization’s specific procedures and methods, and evaluation systems that measure how the person performs will help support a finding that an employment relationship exists.
Evidence that you’ve the right to control the financial aspects of the work also indicates an employment relationship. The IRS is more likely to deem an individual an IC if he or she incurs significant unreimbursed expenses and has a self-employed business with the potential of profit or loss. The IRS also looks at whether the organization provides the tools or supplies for the job, and if the individual is available to work for other companies or clients.
The IRS also considers the payment method. ICs typically are paid a flat fee for a contract or job, while employees generally are guaranteed a regular wage amount for an hourly, weekly or biweekly period. In many cases employees are provided with traditional benefits, such as health insurance, retirement benefits and paid vacation days. An IC paid under these terms could raise a red flag with the IRS.
Employer-worker relationships count
A written contract between the employer and the IC, spelling out terms and making explicit the nonemployee status, shows how both parties view the relationship. While only a factor in the IRS determination, it can cover the aspects that make a person count as an IC.
The duration of the relationship is relevant, too. Does it continue indefinitely (more like an employee) or only for the run of a specific project or period (more likely an IC)? Similarly, if the worker provides services that are critical to the nonprofit’s operations, the employer is more likely to have the right to control his or her activities. Thus, he or she is more likely to be classified as an employee.
The consequences of improperly treating an employee as an IC can be severe. You may be liable for unpaid back taxes (including the worker’s share), plus penalties and interest. Other risks exist. For example, ICs reclassified as employees may bring claims to recover benefits, wages and other rights associated with employee status. Your CPA can provide more advice on classification to make sure you get it right.