A common issue that arises at small nonprofit organization is how to classify the individuals who perform work for them. Nonprofit organizations have to determine whether individuals are independent contractors or common law employees. This blog post discusses how to distinguish the two types of workers, filing requirements for each type of worker and the potential consequences of misclassification.
The first factor to consider is the amount of control the employer has over the work being done by the individual.[i] Is the worker free to control the work he or she is submitting, and, if so, to what degree? In considering the control factor, the IRS looks at several types of control: behavioral control, financial control, and the type of relationship between the worker and organization.[ii]
Behavioral control concerns factors such as the instructions given by the organization to the worker.
Does the organization direct when and where the work will be completed?
Does the organization prescribe what instruments and materials to use?
Does the organization control who the worker hires to complete the projects? Does the organization dictate the order and sequence in which the work is completed?
Does the company control where the worker buys supplies from?
The more the organization seems to direct and control these types of details, the more likely it is that the worker is not an independent contractors.
Financial control considers how much direction and control the organization has over the business aspects of the worker’s job. Is the worker reimbursed for business expenses? Independent contractors are less likely to be reimbursed for business expenses than a common law employee. Another consideration is how the worker is paid. Employees tend to have set hourly wages or salaries. Independent contractors are typically paid either flat rates or for set time or materials. Another important consideration is that independent contractors are typically able to freely seek out business opportunities. If the worker is limited in this aspect, then the worker is likely an employee.
The type of relationship between the worker and organization is an important factor.[iii] Is the relationship permanent? If so, the worker is likely an employee. Is the worker getting benefits such as insurance? If so, then the worker is also likely an employee. Is the work being performed a key aspect of the organization’s regular business? If the work being performed is part of a key aspect of the organization’s regular business, the organization likely has more direction and control over such work. This would be indicative of a common law employee.
For employees, nonprofit organizations have to withhold income taxes, withhold and pay social security and Medicare taxes, and pay unemployment taxes on wages paid to employees.[iv] Generally, organizations do not have to withhold or pay any taxes on payments to independent contractors.[v] However, if four conditions are met, an employer must generally report a payment as nonemployee compensation.[vi] These conditions are: (1) payment was made to a non-employee, (2) for services in the course of the employer’s trade or business (which includes government agencies and nonprofit organizations), (3) with that payment being made to an individual, partnership, estate or—sometimes—a corporation and (4) these payments were at least $600 during the year.[vii] This is usually done by filing a 1099 for each contractor with the IRS. The independent contractor is also given a copy and must report the total payments received as income on his or her tax filing.
The penalties for misclassification can be severe. If a misclassification occurs, the organization can not only be held liable for the taxes not paid on the wages, but the organization can also be held liable for interest on such wages and additional penalties for the misclassification.[viii]
If a nonprofit organization is having difficulties distinguishing between an independent contractor or a common law employee, a good starting point would be IRS.gov, which lays out all the factors mentioned above. Additionally, examples of the two types of relationships are described by the IRS here: https://www.irs.gov/pub/irs-pdf/p15a.pdf.[ix]
If you have questions about your nonprofit’s workers status please schedule an appointment with Side Project Managing Attorney Jeff Fromknecht today.
[i] Internal Revenue Service, Employer’s Supplemental Tax Guide, Publication 15A (December 23, 2015), available at https://www.irs.gov/pub/irs-pdf/p15a.pdf.
[iv] Internal Revenue Service, Exempt Organizations: Independent Contractors vs. Employees (March 19, 2016), available at https://www.irs.gov/charities-&-non-profits/exempt-organizations:-independent-contractors-vs.-employees.
[vi] Internal Revenue Service, Reporting Payments to Independent Contractors, (June 14, 2016), available at https://www.irs.gov/businesses/small-businesses-self-employed/reporting-payments-to-independent-contractors.
[viii] Internal Revenue Service, Exempt Organization: Independent Contractors vs. Employees, supra note 18.
[ix] Internal Revenue Service, Employer’s Supplemental Tax Guide, Publication 15A(December 23, 2015), available at https://www.irs.gov/pub/irs-pdf/p15a.pdf.