Learn more about Craig on NerdWallet’s Ask an Advisor
It has become very common, especially among startups, for businesses to classify some workers as independent contractors rather than employees. Doing so can save companies a significant amount of money in payroll taxes. This may be great for business, but it can be costly for workers — because the full burden of those taxes then falls on them.
Employers and employees normally split the cost of Social Security and Medicare taxes. Workers pay 7.65% of their income, and employers kick in a matching 7.65%, for a total of 15.3% per employee. If you find yourself classified as an independent contractor rather than an employee, you have to pay both halves of the tax yourself, because contractors are considered self-employed. This 15.3% is referred to as self-employment tax, and it’s on top of the income taxes you must pay at your ordinary income tax rate.
Many people who are really employees get classified as independent contractors and end up shouldering more of the payroll tax burden, in addition to being denied any benefits and legal protections that employees are entitled to. To protect yourself from misclassification, it’s important to understand how workers are classified.
What is an employee?
The IRS doesn’t have a universal definition of what makes someone an employee rather than an independent contractor. It depends on the individual circumstances of your work arrangement, but factors that could lead the IRS to consider you an employee include:
- You work under someone’s direction.
- You’re paid by the hour or by the piece.
- You work at your employer’s location.
- You have your own desk or workstation at the employer’s location.
- You have set hours.
- You use your employer’s tools, equipment or computers.
- You meet with clients under the guise of your employer.
This is not an exhaustive list, but it includes most of the issues the IRS asks about regarding employment status.
If you are truly an independent contractor, the following would typically apply:
- You would be able to set your own hours.
- You would not work under someone’s direction. (Someone could give you guidance but could not direct you to work in a specific manner.)
- You could work from your own location.
- You would have your own tools, equipment or computer.
- You would be able to take on other clients or customers and do the same work for them.
What to do if you are misclassified
If you are misclassified as an independent contractor, there are some steps you can take at tax time to remedy the situation.
When filing your tax return, you can list the amount that was paid to you by your employer as wages, instead of putting it on Schedule C as self-employment income. This means you would be responsible for paying half of the Social Security and Medicare tax (7.65% of income, rather than the 15.3% required of self-employed taxpayers), plus income tax.
You would also need to file Form SS-8 with the IRS. This form asks the IRS to determine whether you are an employee or a contractor. It includes several pages of questions about your work arrangement.
There is one important consideration if you decide to use this strategy and you are still working for the employer (or you’re worried about burning bridges): You can’t do it in secret. When you file the SS-8, the IRS will initiate a formal employment tax investigation against your employer. If all workers are being improperly treated as independent contractors, the company could owe tens of thousands of dollars, or more, in employment taxes. This could upset your employer and cost you your job. So make sure you are comfortable with the implications before using this strategy to reduce your tax burden.
This article also appears on Nasdaq.
Image via iStock.