That may seem to be an odd question. You may think that if you work for a business, and the business gives you a paycheck for your services, then you are an employee. Right? Well, maybe.
Others may think that the answer may seem to be obvious – when the individual is an independent contractor. But an independent contractor is, by definition, not an employee.
Correctly classifying employees can be tricky businesses.
The real import of the question is this: When is an individual who is working for a business as an employee not treated as an employee? The distinction is a real one, and the answer is important.
There are at least five reasons for making the correct determination:
- A business may provide fringe benefits to any individual who performs services for the business, but only employees may have a portion or all of the certain fringe benefits excluded from income.
- All compensation paid to an employee is defined by law as to wages. Compensation paid to a non- employee may be defined differently.
- Employers are legally obligated to withhold income taxes on the wages of employees, and deposit those taxes with the appropriate tax agencies. Non-employee compensation is not subject to any tax withholding.
- Employers are required to pay social security, Medicare, and state and federal unemployment taxes on wages.
- Only employee income is reported on Forms 941, W-2 and 940.
So how do we answer the question? There are basically two conditions that may affect whether or not an individual working as an employee is an employee:
- The tax law specifically states that certain employees are to be treated as non-employees in specific situations, and
- The legal structure of the business requires that certain individuals be treated as non-employees.
The first condition is primarily connected to the issue of fringe benefits. As discussed in the article The Ins And Outs of Fringe Benefits, it was noted that the value of certain fringe benefits may not be excluded from an employee’s income because the employee may be defined as a non-employee for that specific benefit. For instance, an employee of an S-Corporation who owns 2% or more of the corporation’s stock is not an employee who qualifies to have medical benefits excluded from income.
Of more serious concern is that under certain legal structures, an individual may not be treated as an employee for the payment of wages. In the following sections, we will discuss each of these legal structures that are affected.
Legal Structures That Affect Employee Classification
Corporations and S-Corporations
A corporation is a separate legal entity that is subject to corporate taxes. An S-corporation is a hybrid corporation that distributes the value of corporate profits to its shareholders.
Unless an individual is classified as an independent contractor, any individual working for a corporation must be treated as an employee. All wages are reported on Form W-2 at the end of the year.
Sole proprietors, partners in a partnership, and the members of a limited liability company are never paid wages because they are considered to be self-employed. So how do such individuals take money out of the business? Through the “owner’s draw.”
The sole proprietorship is at the other end of the business entity spectrum. A single individual owns the business, and in many cases, the owner of the business may be the only person working for the business. However, a sole proprietor can hire employees and pay independent contractors, and payments and taxes paid are deductible expenses that reduce the owner’s taxable profit.
The owner of the business must attach a Schedule C to his personal Form 1040 at the end of each year. The owner of the business is also subject to the self-employment tax on his taxable profit and is required to attach Schedule SE for the self-employment tax to his Form 1040. Sole proprietors are also required to make quarterly estimated tax payments.
If the owner takes any payments from the business, these are recorded as owner’s draws that reduce the business’s equity. Owner’s draws are not reported on any tax returns.
A partnership is similar to a sole proprietorship in that the partners are treated as self-employed individuals, but there are two or more owners of the business. However, that’s where the similarity ends.
Each partner in a partnership has a percentage share of the business based on the partnership agreement. The profits or losses of a partnership are reported on Form 1065 and are allocated to each partner based on the percentage of ownership. The partner’s distributive share of profit or loss is reported on a Form 1065, Schedule K-1. The partner has to complete a Schedule E based on this Schedule K-1 and attach it to his Form 1040.
Unlike a corporation, partners who work for the partnership are never treated as employees. That means they can never be paid as employees with the partnership withholding taxes. Fringe benefits received by partners cannot be excluded from income because they are not employees.
A partner may receive a regular payment for services performed and fringe benefits, but these are classified as guaranteed payments to the partner. These payments are reported on the partner’s individual Schedule K-1 and they are subject to self-employment tax. Fringe benefits that may be provided to a partner are also included in guaranteed payments on the Schedule K-1, and a partner may be able to report some fringe benefits (such as health insurance) as a deductible expense on the partner’s individual Form 1040 at the end of the year. Fringe benefits paid on behalf of partners are deductible expenses for the partnership and do reduce the partnership’s profits.
Since all guaranteed payments made to partners are treated as self-employment income, a partner must make quarterly estimated tax payments on his income. A partnership may have employees, and these employees are treated the same as employees in any other business. However, payments made to employees are deductible expenses on a partnership’s books, thus reducing the company’s profits. The total of guaranteed payments made to partners is also be deducted from the partnership’s income because each partner is taxed separately on the partner’s personal tax return.
Limited Liability Companies
A limited liability company, or LLC, is a hybrid type of business. The owners of an LLC are called members. It has many of the legal protections of a corporation in that personal assets are protected from being attached to meet LLC liabilities, but the owners of the LLC are taxed as either sole proprietors if there is a single member, or as partners if there are two or more members.
Like a sole proprietorship or a partnership an LLC can have employees, but the members of the LLC are self-employed individuals. The profits of an LLC are either reported on a Schedule C for an individual or on a Form 1065, Schedule K-1 for partners.
Owners Of Businesses Have Flexible Status
So when is an employee not an employee? From the above discussion, it should be clear that there are times when individuals who are owners of a business and who work for a business as an employee may by definition not be employees. The distinction is important because it affects how payments to the individual are treated for tax purposes and tax reporting.