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Who is an Employee?
An employer must withhold federal income tax, social security and Medicare (FICA) taxes from an employee's wages. In addition, an employer must pay its share of FICA taxes and pay federal unemployment (FUTA) tax based on wages paid to employees. However, an employer is not required to pay FUTA tax, withhold or pay FICA taxes, or withhold federal income tax from payments made to nonemployees, a.k.a. independent contractors. The employer's classification of a worker does not determine the worker's status. The worker's status depends on the actual relationship that exists between the employer and the worker. How the parties label their relationship does not matter when the employer-employee relationship exists for tax purposes. Moreover, the IRS will reclassify the relationship when it does not agree with the parties' classification. There is no age limit on FICA tax liability. Thus, an employee who has reached retirement age but continues to work still must pay FICA taxes. Similarly, an employee receiving social security benefits must continue to pay FICA taxes if she receives wages (Reg. §31.3101-3; IRS Pub. 15 (Circular E) Employer's Tax Guide). A disabled worker is not liable for FICA taxes on wages paid after the year he became entitled to disability insurance benefits under the Social Security Act. This exception applies if the disabled worker did not work for the employer during the period for which the payment is made (Code Sec. 3121(a)(15)). The statutory definition employee differs somewhat for FICA, FUTA, and federal income tax withholding purposes. However, it is important to differentiate between an employee and an independent contractor for all three taxes. Employees for FICA Tax Purposes Employee wages from employment are subject to social security and Medicare (FICA) taxes. Generally, employment refers to services performed by an employee for an employer. Comment - Employers are not required to withhold FICA taxes from payments to independent contractors. However, independent contractors generally must pay self-employment tax under the Self Employment Contributions Act (SECA). The self-employment tax serves the same purpose as FICA taxes and is paid at the same rate (Code Sec. 1401). Wages received from full-time, part-time, and temporary employment are subject to FICA taxes. Also, if the employer-employee relationship exists, the fact that the parties designate or describe the employee as a partner, independent contractor, or independent consultant is irrelevant. Comment - For an employee's wages to be subject to FICA taxes the services performed must be employment for FICA purposes. Four types of individuals are considered "employees" for FICA tax purposes:
Comment - A state and the Social Security Administration (SSA) may agree to extend social security and/or Medicare coverage to state employees (and/or employees of its political subdivisions) who are not required to be covered. These agreements are commonly known as SSA Sec. 218 agreements. Corporate Officers as Employees A corporate officer is an "employee" for FICA tax purposes. This includes officers of S corporations (Code Sec. 3121(d)(1); Rev. Rul. 73-361). A corporate officer who performs only minor services and who does not receive any payment is not an employee (Rev. Rul. 74-390). A corporate director is not an employee in his capacity as a corporate director (Reg. §31.3121(d)-1(b)). Members of an organization's executive committee are also not employees when their function is the same as that of directors (Rev. Rul. 68-597). Comment - Unlike corporate officers, partners are generally not partnership employees; they are self-employed (CCA 200117003). Thus, the partnership is not required withhold or pay FICA taxes, but the partner must pay self-employment tax (Code Sec. 1402). Common Law Employees An individual providing services to an employer under circumstances that create an employer-employee relationship is a common law employee. There is no statutory definition of a common law employee, but the IRS has provided guidance to help identify these workers. Generally, an employer is required to withhold and pay FICA and withhold income taxes and pay FUTA for common law employees. Comment - FICA and federal income tax withholding are not required for payments made to independent contractors. However, when a business pays $600 or more during the year to an individual providing service to a business, the business must file a Form 1099-MISC with the IRS. A business is not required to report payments of $600 or more made to a corporation, including an S corporation. Statutory Employees Generally Statutory employees are individuals who are treated as employees for FICA and FUTA tax purposes (Reg. §31.3121(d)-1(a)). There are four categories of individuals who are employees for FICA purposes if they meet certain criteria:
Comment - A statutory employee's employer must withhold and pay FICA taxes even if the individual would be treated as an independent contractor under the common law rules. Such an individual is a statutory employee if:
Comment - To meet this test, no material service may be delegated to another person. However, the test is still met if the individual providing the service has occasional assistance. Whether this requirement is met depends on all the facts and circumstances of a particular case (Reg. §31.3121(d)-1(c)(3)).
Comment - If an individual has a substantial investment in facilities used to perform services for the employer, that individual is not a statutory employee. The requisite investment must be in facilities that may not be used for purposes other than providing the services. Thus, a home office is not a substantial investment in facilities. In addition, the investment must be in a facility other than transportation. (Reg. §31.3121(d)-1(d)(4)). Example Annie purchased a computer to provide transcription services for Greg. Annie's computer purchase was not a requisite investment in a facility because the computer could be used for purposes not related to her transcription services for Greg (Rev. Ruls. 70-340, 64-280). Similarly, Adam purchased a sewing machine, shears, and an iron to provide tailoring services to Field's. Adam's purchases were not a requisite investment because they could be used for purposes not related to the services he provided to Field's (Rev. Rul. 72-88).
Comment - The fact that the individual's services are not performed on consecutive workdays does not indicate they are not performed as part of a continuing relationship (Reg. §31.3121(d)-1(d)(4)(iv)). Comment - The statutory employee rules do not apply for income tax withholding purposes. An individual is an employee for income tax withholding purposes only if the individual is an employee under common-law test. Thus, individuals who classified as statutory employees are not employees for income tax withholding purposes and are permitted to deduct their business expenses from gross income on Form 1040, Schedule C, Profit or Loss from Business (Rev. Rul. 90-93). Example Annie worked for Greg as a life insurance agent during the first two months of 2012. Greg paid Annie $6,000 for the services she performed. Annie was Greg's statutory employee. Thus, Greg must withhold and deposit FICA taxes; file Form W-2, Wage and Tax Statement, and give a copy to Annie. When completing Form W-2, Greg should check the Statutory Employee box. In boxes 1, 3 and 5, Greg records Annie's compensation ($6,000). In box 4, Greg records the social security tax withheld ($6,000 × 4.2% = $252) and in box 6 the Medicare tax withheld ($6,000 × 1.45% = $87). As a statutory employee, Annie reports her earnings on Form 1040, Schedule C, Profit or Loss from a Business. Annie can deduct her trade or business expenses from the amount shown on Form W-2 in box 1. Annie's business expenses are also reported on Schedule C, not Schedule A, Itemized Deductions. Thus, Annie's trade or business expenses are not subject to the 2 percent of adjusted gross income floor that applies to common law employees. A corporate officer or a common law employee is treated as an employee based on that status rather than as a statutory employee (Colvin, CA-5, 2008-2 USTC ¶50,450). Agent-Drivers or Commission-Drivers An agent-driver or commission-driver engaged in distributing meat, vegetables, fruit, bakery goods, beverages (other than milk), or delivering laundry or dry-cleaning is a statutory employee for FICA purposes. An agent-driver or commission-driver is an individual who:
An employer may take into account an agent-driver or commission-driver's ordinary and necessary distribution expenses when calculating the driver's "wages" for employment tax purposes (Rev. Rul. 73-260). To use this method, the driver must submit a statement to his employer showing:
The employer may then calculate the driver's wages as follows:
However, if the driver does not submit the required statement, the employer calculates the driver's wages as follows:
Full-Time Life Insurance Salesman A full-time life insurance salesman's principal business activity is selling life insurance and/or annuity contracts primarily for one insurance company (Rev. Rul. 54-312). Such a salesman generally uses the office space provided by the company or its general agent, and stenographic assistance, telephone facilities, forms, rate books, and advertising materials are usually made available without cost. A general insurance agent who sells insurance for more than one company or who sells insurance on a part-time basis is not a full-time life insurance salesman and, therefore, is not a statutory employee. A disabled former insurance agent who is still under contract should not be considered a statutory employee when all parties understand that the contract is only a formality to allow the former agent to participate in the firm's benefit plans (CCA 200203005). Home-Workers A home-worker is treated as a statutory employee if the individual:
Thus, individuals solicited to weave Christmas wreaths at home, using company supplied frames, but otherwise using their own materials, without company instruction, direction, or control, and who were under no obligation to sell the finished wreaths to the company, were not statutory employees (Rev. Rul. 74-62). Traveling or City Salesman A traveling or city salesman is engaged full-time soliciting orders from wholesalers, retailers, contractors, or hotel operators, restaurants, or other similar establishments for resale merchandise or supplies for use in their business operations. A traveling or city salesman is a statutory employee for FICA purposes. To be a statutory employee, the salesman's principal business activity must be soliciting orders on behalf of just one employer. This requirement does not prohibit side-line sales for other suppliers, but if the salesman works for more than one supplier, then he is not a statutory employee (Rev. Rul. 73-374). House-to-house salesmen are not statutory employees. Only salesmen who solicit orders from the enumerated businesses (wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments) for resale merchandise or supplies for use in their business operations are statutory employees. Employees for FUTA Tax Purposes An employer must pay FUTA tax based on the wages paid to employees. Generally, an employee for FICA purposes is an employee for FUTA purposes. However, there are only two categories of statutory employee for FUTA purposes. Thus, for FUTA purposes, the term employee includes:
Employees for Income Tax Withholding Purposes An employer is required to withhold income taxes from wages paid to employees. Thus, income tax must be withheld from wages paid to common law employees. A corporate officer is an employee for income tax withholding purposes. The term employee for withholding purposes also includes an officer, employee, or elected official of the United States, a state or a political subdivision of a state, the District of Columbia, or any agency or instrumentality of any such governmental entity (IRS Letter Ruling 200146006; IRS Letter Ruling 200119035). There is no provision for withholding income tax from wages paid to statutory employees. Thus, an employer is not required to withhold income tax from employees who are statutory employees for either FICA or FUTA purposes, unless they are also common law employees. Statutory nonemployees are individuals who are not employees regardless of their relationship with their employer. Statutory nonemployees include:
Also, individuals such as physicians, lawyers, dentists, veterinarians, construction contractors, public stenographers, and auctioneers, engaged in the pursuit of an independent trade, business, or profession, in which they offer their services to the public, are independent contractors and not employees (Reg. §31.3121(d)-1(c)(2)). Qualified Real Estate Agents Related Information – Federal An individual performing services as a qualified real estate agent (QREA) is a statutory nonemployee. Consequently, the person for whom the QREA provides services is not an employer and that person is not required to withhold employment taxes from payments made to the QREA (Code Sec. 3508(a)). QREA's are nonemployees for employment tax purposes for real estate services performed as a QREA even if they would otherwise qualify as a statutory employee. Thus, QREAs are self-employed and must pay self-employment taxes (Code Sec. 1402). An individual is a qualified real estate agent (QREA) if:
"Substantially all" means at least 90 percent of the individual's real estate compensation is directly related to sales or other output. Compensation is directly related to sales or other output if it is paid, awarded, or credited to the individual on the basis of one or more specific sales transactions or the accomplishment of one or more specific tasks. However, fixed periodic payments made for services rendered without regard to sales or output are payments made on the basis of hours worked. Compensation based on another agent's sales or output qualifies as real estate compensation if it is paid, awarded, or credited on the basis of the other individual's specific sales transactions or the accomplishment of specific tasks. Compensation an individual receives from a pool is directly related to sales or other output only to the extent it does not exceed the amount the individual would have received, absent the pool, for specific sales transactions or the accomplishment of specific tasks (Prop Reg. §31.3508-1(d)). Services performed as a real estate agent include recruiting, training, and supervising other individuals who make sales, advertising or showing real property and real estate appraisal in connection with the sale of real property. A property manager is not a qualified real estate agent (Prop Reg. §31.3508-1(b)(2)). Appraisals must be only an incidental service in connection with real estate sales, and not a separate function. Loan officers whose function is to solicit and arrange loans pertaining to real estate are not "qualified real estate agents" even though they may be a real estate sales person under state law (IRS Letter Ruling 9648003). Direct Seller An individual performing services as a direct seller is a statutory nonemployee. Consequently, the person for whom the direct seller provides services is not an employer and that person is not required to withhold employment taxes from payments made to the direct seller (Code Sec. 3508(a)). Direct sellers are nonemployees for employment tax purposes for services performed as a direct seller even if they would otherwise qualify as a statutory employee. Thus, direct sellers are self-employed and must pay self-employment taxes (Code Sec. 1402). An individual is a direct seller if:
"Substantially all" means at least 90 percent of the individual's compensation for services as a direct seller is directly related to sales or other output. Compensation is directly related to sales or other output if it is paid, awarded, or credited to the individual on the basis of one or more specific sales transactions or the accomplishment of one or more specific tasks. However, fixed periodic payments made for services rendered without regard to sales or output are treated as payments made on the basis of hours worked. Compensation based on another individual's sales or output qualifies as directly related compensation if it is paid, awarded, or credited on the basis of the other individual's specific sales transactions or the accomplishment of specific tasks. Compensation an individual receives from a pool is directly related to sales or other output only to the extent it does not exceed the amount the individual would have received, absent the pool, for specific sales transactions or the accomplishment of specific tasks (Prop Reg. §31.3508-1(d)). Gray Area - "Consumer products" are not necessarily tangible personal property. Consumer products may also be consumer services, such as educational courses or cable television subscriptions (Cleveland Institute of Electronics, Inc., DC Ohio, 92-1 USTC ¶50,182; The R Corporation , DC Fla., 94-2 USTC ¶50,380). Direct seller sales may be to a buyer for resale on a buy-sell basis or a deposit-commission basis. Consumer product installation may be included as part of the direct seller's sales only if the value of the installation does not exceed 10 percent of the products price including the installation. Direct selling also includes recruiting, training, motivating, and counseling other direct sellers. No Presumption The qualified real estate agent/direct seller rules apply only to individuals who qualify. An individual who does not qualify under these rules is not presumed to be an employee. Further, the person for whom the individual performs services is not presumed to be an employer. Other Services An individual who performs both
may be an employee with respect to those other services for employment tax purposes. Whether the individual is an employee or an independent contractor is decided under the common law employee rules. Example Max is the broker/manager for RealT, a real estate agency. He is a statutory nonemployee with respect to his real estate brokerage services because he is a qualified real estate agent. However, Max's status with respect to his management services would be determined under the common law rules (IRS Letter Ruling 200033014). Placement Agencies for Babysitting or Similar Services Babysitting or similar service agencies are not the sitters' employer for employment tax purposes. Babysitters and other such service providers are not employees of the placement agency for employment tax purposes. However, this rule only applies if the placement agency does not pay the sitter's wages and is compensated by the sitter or the client on a fee basis. This rule applies to individuals who furnish personal attendance, companionship, or household care services not only to children, but also to the elderly or disabled. Under this rule such sitters are self-employed and are subject to self-employment tax (Code Sec. 1402). Caution - This provision does not apply to any employer-employee relationship that may exist between the sitter and the client. If the agency pays the sitters' wages or controls their performance the agency may be the sitter's employer. For example, temporary nurses who secure their job assignments through an agency and were paid by the agency at a predetermined rate, have their performance evaluated periodically by the agency, and are required by the agency to inform it of their availability to work are the agency's employees under the common law rules (Rev. Rul. 75-101). Example Contact is a placement agency for babysitters. Contact screens the sitters and provides them with guidelines for their conduct and appearance. Contact also requires all sitters to file semimonthly reports about the clients and determines the client's fee. On Friday, Britney called Contact to obtain a babysitter for Saturday night. Contact told Britney that the fee would be $25 per hour for an experienced, screened sitter named Kevin. Britney agreed to the fee and Kevin babysat Britney's children on Saturday night. Britney paid Kevin $125 for babysitting. Kevin then paid 10 percent to the agency as a placement fee. Since Contact did not pay or receive Kevin's wages, Contact is not Kevin's employer for employment tax purposes and Kevin is self-employed (Reg. §31.3506-1(e)). However, when the agency pays workers to perform domestic services for the agency's clients, the workers are the agency's employees for employment tax purposes if:
Example Same facts as Example above, except that Britney paid Contact the $125 plus the 10 percent placement fee. Contact retained the 10 percent and paid Kevin the $125. Contact is Kevin's employer because it received and paid Kevin's wages (Rev. Rul. 56-502, modified by Rev. Rul. 80-365). |
