Vol. 14, No. 5a, Pg. 14. A practical guide to understanding state and federal tax obligations based on worker classification.

AuthorBy Anthony E. Rebollo

South Carolina Lawyer


Vol. 14, No. 5a, Pg. 14.

A practical guide to understanding state and federal tax obligations based on worker classification

14A practical guide to understanding state and federal tax obligations based on worker classificationBy Anthony E. RebolloThe question whether a particular worker or group of workers should be categorized as independent contractors or employees is a critical one for both state and federal tax purposes. In general, no income tax or employment tax (FICA) withholding is required when making payments to contractors, whereas the opposite is true with employees. The appropriate classification of workers is also a key consideration for unemployment tax purposes, since employers are required to pay unemployment taxes based on the amount of wages paid to "employees." Payments to independent contractors, on the other hand, would not subject the employer to the unemployment tax.

16In examining this issue, the federal and state governments apply various definitions and tests. While the definition of "employment" for South Carolina tax purposes (for the most part) tracks the Internal Revenue Code definition, there are several differences. Understanding the different definitions is essential for several reasons: (1) to avoid an incorrect classification of workers (which can, and frequently does, lead to the imposilion of large, unanticipated tax liabilities), (2) to successfully resist an adverse determination by the government and (3) to minimize liabilities in the event that an adverse determination is sustained.

Classification of workers for federal tax purposes

The common law test

The definitions of "employees" and "independent contractors" for federal tax purposes are the same as the common law definitions of those terms. Based on those definitions, the IRS has identified 20 factors to determine whether sufficient control is present to establish an employer-employee relationship. Rev. Rul. 87- 41, 1987-1 C.B. 296. The factors include considerations such as whether the worker is required to work during specific hours or is provided with any training; whether the worker incurs and pays for his own business expenses; and whether the worker is free to work for others. Each factor is designed to assist in determining who controls or has the right to control the details of the work being performed. If it is the worker, he should be classified as an independent contractor.

If a worker is an independent contractor under the common law test, the individual or business making payments to him will not be required to withhold income tax from the payments. Nor, in the vast majority of cases, will the payor need to withhold employment taxes (i.e., FICA) or pay federal unemployment taxes (i.e., "FUTA"). Instead the taxpayer will usually be required simply to report the annual amount of payments made to the worker on an IRS Form 1099.

There are a few circumstances where, by statute, certain limited categories of workers are treated as independent contractors, even though they would qualify as employees under the common lawtest. These groups of workers include certain licensed real estate agents...

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