Many private schools rely on the support of independent contractors to enable them to fulfill their mission. But when certain conditions are met, it’s easy for an individual who was previously classified as an independent contractor to be characterized as an employee.
Understanding the distinction between an independent contractor and an employee is an important concept for independent schools. The obligations that the school has towards an individual who is an employee are entirely different from the more limited obligations they have toward an independent contractor.
Failing to correctly understand these distinctions can have major implications for independent schools, particularly if they are found to have misclassified employees as independent contractors. Schools could find themselves on the hook for several years of back taxes, plus penalties and interest.
In this overview, we break down the key distinctions to determine whether an individual should be considered an independent contractor or an employee.
An independent contractor is a self-employed professional in an independent trade, business, or profession that offers services to the general public.
Schools are obligated to report qualified payments to an independent contractor to the IRS on Form 1099-NEC. It’s possible schools could be required to handle backup withholding, but only if the independent contractor’s taxpayer identification number was invalid and unable to be corrected before the IRS instructed the school to begin backup withholding.
An employee is an individual who is employed by an employer.
Employers are obligated to comply with labor laws, including overtime rules, offering employee benefits fairly across all employees, and participating in unemployment insurance. Employers also have tax obligations when it comes to employees, including withholding and payment of social security, Medicare, unemployment, and income taxes, plus any additional employment taxes.
In general, the question of whether an individual is an employee or independent contractor boils down to the ability the employer has to direct and control the work of the individual. The IRS provides three common law rules that determine whether an individual should be considered an independent contractor or an employee: behavioral, financial, and the type of relationship between the two parties.
Independent schools must consider all of these facts. No one set of facts is more important than the other, and there is no bright-line distinction that absolutely characterizes an individual as an independent contractor or an individual. Instead, this determination should be made by weighing all of these factors.
As we examine the factors below, we’ll consider the hypothetical example of a school sports coach – a position that is often mistakenly classified as an independent contractor when it should be classed as an employee.
For independent contractors, a school has every right to guide and dictate the outcome of a task. They do not, however, have the right to decide how that outcome is achieved.
In the example of the sports coach, the school can specify that they want the coach to manage a certain sports team for the season. Let’s say the coach manages the baseball team. If the coach were an employee, the school could require certain equipment to be used, could specify the timing of training sessions to fit with the school’s schedule, and could require the training to take place on the school’s baseball field. But if the coach were to be considered an independent contractor, the school would have no control over these decisions.
Independent contractors typically have more than one source of revenue, working for multiple organizations at the same time. Employees, on the other hand, tend to be entirely dependent on their employer for their economic security.
There are additional financial considerations. Independent contractors typically supply their own equipment. An independent contractor baseball coach will supply their own baseball bats, batting cages, and so on. In an office-based scenario, an independent contractor would supply their own computer and software. Employees are typically provided with relevant supplies by their employer, in the way that a teacher is provided with textbooks and a certain amount of money to purchase classroom supplies.
The relationship between an individual and an organization is typically documented in a contract.
Independent contractor contracts are usually fairly straightforward: they promise to provide an agreed-upon service in exchange for financial compensation. The contract typically ends after a period of time. In our baseball coach example, the contract may specify that the coach will receive a series of payments in return for coaching the team, with the contract ending once the season is over.
Employment contracts contain information on the salary and benefits the employee will receive, such as health insurance or participation in a 401(k) plan. Independent contractors are not eligible for these types of benefits. Employment contracts also tend to be indefinite, unlike independent contractor contracts, which typically have a fixed end date.
Mischaracterizing the relationship between an employee and the employer poses potentially serious risks to the school. It’s not uncommon for schools to pay an individual as an independent contractor who is functioning more as an employee. This can happen over time as the independent contractor’s role evolves.
Failing to appropriately characterize the employee-employer relationship can lead independent schools to underpay taxes, from employment taxes including social security and Medicare taxes to state unemployment taxes.
Often, individuals who work for your organization in an independent contractor capacity may not be aware of the distinction between an independent contractor and an employee. When your relationship with an independent contractor ends, they may claim unemployment benefits from the state. This can trigger an investigation into how your school distinguishes between independent contractors and employees.
If your organization is found to be in the wrong, state taxing authorities and the DOL may conduct a more in-depth audit that examines every independent contractor relationship your school has had in recent years. Depending on the gravity of the issue, schools may find themselves being assessed for several years of back taxes plus penalties and interest.
There is no question that appropriately classifying individuals as either independent contractors or employees is an extremely important task from a compliance perspective. School leaders should work to bring clarity to the behavioral, financial, and type of relationship considerations outlined by the IRS.
If schools remain unsure, they may proactively reach out to the DOL for assistance or submit IRS Form SS-8. Taking a proactive approach to ensuring employees are correctly categorized is the most favorable route for independent schools to take, minimizing the potential for penalties and giving schools more control over the process.
At Smith + Howard, we’re proud to serve as advisors to a diverse range of independent schools across the country. Our experienced professionals provide guidance on a range of compliance requirements and are available to assist independent schools with various tax registrations and filings.
To learn more about our accounting and advisory services for independent schools, contact an advisor today.
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