Deciphering employee vs. independent contractor

What an exciting time in your business, if you have gotten to the point where you need to add to your team!

Sometimes you can hire contractors (to outsource some work) but sometimes it makes better sense to hire an employee. We’ll go over the differences between ‘independent contractor’ and ‘employee’ from the IRS’s standpoint, so you have all the info you need to make the right choice for your business. Next week, we’ll talk about the money side of hiring one vs. the other.

The IRS has a 3-factor approach to determining who is an independent contractor vs. an employee. Those 3 factors are: Behavioral Control, Financial Control and Relationship of the Parties.

Behavioral Control

A worker is considered an employee if the business has the right to direct and control the work performed, even if that right isn’t exercised.

These are examples of behavioral control that would indicate the worker should be an employee:

  • The business decides when and where the worker does the work

  • The business decides what tools are used

  • The business decides where to purchase supplies and services

  • The business gives detailed instructions on how to perform the work

  • The business trains a worker on how to do the job, or has periodic training on process and procedures

These are examples of behavioral control that would indicate the worker could be classified as an independent contractor:

  • The worker receives less detailed instructions on how to perform the work

  • The business uses evaluation systems measuring just the end result *

  • The worker uses his/her own methods for completing the job

Financial Control

The worker may be considered an employee if the business has the right to direct or control the financial aspects of the worker’s job.

These are examples of financial control that would indicate the worker could be an employee:

  • The business pays for the tools for the worker to complete the job (i.e. computer, phone, work vehicle, tools of the trade, etc.)

  • The business reimburses the worker for expenses

  • The worker is not free to seek out other opportunities, or works exclusively for the business

  • The worker is guaranteed a regular wage, hourly, or commission based

These are examples of financial control that would indicate the worker could be an independent contractor:

  • The worker has made a significant investment in the tools to complete the job

  • The worker has unreimbursed expenses, like marketing, advertising, mileage and other costs incurred to run their own business

  • The worker is free to seek out other opportunities

  • The worker is often paid a flat fee or by the job instead of hourly wages

Relationship

This all boils down to how the worker and the business perceive their relationship with one another.

These are examples that would point to employee status:

  • Benefits provided, such as paid time off, health insurance, and pension plans

  • An expectation that the relationship will go on indefinitely

  • The worker provides services that are also the key activity of the business

  • There is a contract stating the relationship is intended to be an employee/employer relationship*

These are examples that would indicate independent contractor status:

  • There is a written contract stating that the worker is an independent contractor*

  • There is an expectation that the relationship will terminate after a certain time period or after completion of a project*

*these could go either employee or contractor, so it’s important to have a strong case with your other factors

What happens if you misclassify?

If you were to misclassify an employee as an independent contractor, you (the business) would be liable for the employment taxes. These include Unemployment, Medicare, Social Security, and possibly state employment taxes as well. It is really important that if you are going to classify a worker as an independent contractor, that you have a strong case. Note that a contract between the parties alone is not enough for a strong case.

If you would like assistance in determining worker classification, contact us. We’re happy to talk through the facts with you to get you on the right path. We can also set you up on a great payroll system, if you’re ready to hire employees!


additional resources:

  • The IRS has a small business and self-employed Tax Center with lots of info.

  • A worker can report that they believe they were misclassified as an independent contractor here.

  • You can get help from the IRS determining the worker classification here.

  • You can voluntarily report a misclassification to the IRS and receive some relief from federal employment taxes if you qualify here.

  • Employment Tax Calculator