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Contractor or employee? It's a taxing matter

It's not often that a ruling by the California Labor Commissioner makes national news. But it did this week when it said a driver of ride-sharing service Uber is an employee, not an independent contractor. Why did the ruling get so much attention? It's fueling an already active debate across a number of industries over their classification of workers as contractors instead of employees.

At stake in the California case is the reimbursement of the driver's expenses because the state expressly requires employers to reimburse employees for business expenses. Also at stake is the payment of the employer's portion of Social Security and Medicare taxes. All told, the commission awarded the driver, Barbara Ann Berwick, $4,152.

But the stakes for Uber are far higher, which is why it's appealing. Launched five years ago and now having hundreds of thousands of drivers, Uber has raised billions in capital and has a $50 billion valuation. Classifying drivers as employees could blow a significant financial hole in the business models not only of Uber but of Lyft and other ride-sharing services.

There's another, even broader, issue at play here. If you take on a job as a freelance worker, you'll need to be clear about whether you're really an independent contractor or an employee. From the perspective of the IRS, for federal tax purposes this really matters. It affects how and what taxes you pay, and how you file your tax returns.

The IRS and tax courts have ruled that a number of facts must be considered in deciding whether a worker is an independent contractor or an employee. These facts are grouped into three categories: behavioral control, financial control and relationship of the parties.

The core of this decision is the issue of control. Does the company you work for control when you do your work, the manner in which you do it, who you can hire, what equipment you use, etc. The more freedom you have over these and other aspects of your work, the more likely you are to be an independent contractor. The IRS also publishes these Tips for Business Owners to help employers in classifying the people they hire as employees or freelance workers.

Once you're clear that you're an independent contractor, you'll need to know some things about the taxes you'll owe.

One special tax that trips up a lot of small-business owners is the self-employment tax, also known as the SE or SECA tax (for the Self-Employment Contributions Act). This is essentially the same as the FICA tax that employers and employees pay for Social Security and Medicare.

Many newly self-employed are surprised to find that they pay a lot more in taxes than an employee pays. That's because as a contractor, you're required to pay the full amount of the Social Security and Medicare tax based on your earnings or net profit from self-employment. When you're an employee, your employer pays half this tax.

The SE tax has three parts that self-employed individuals must pay:

12.4 percent Social Security tax. For 2015, this tax applies to the first $118,500 of net profit or earnings from self-employment. If you have earnings above this amount, those earnings aren't subject to this tax (and remember, if you were an employee, you would only pay 6.2 percent as your Social Security tax).

2.9 percent Medicare tax. The Medicare portion of the self-employment tax applies to all earnings from self-employment and all wages from traditional employment, with no earnings limit. Again, noncontract employees would pay 1.45 percent.

0.9 percent Medicare surtax. Created under the Affordable Care Act, this extra Medicare tax applies to income from self-employment and wages that exceed $200,000 for single filers and $250,000 for married filers. Contractors and employees alike pay all of this tax, with employers paying none.

For more information, see IRS Tax Topic 554 - Self-Employment Tax.

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