If you are an employer bringing on a new worker, you may be tempted to classify the worker as an independent contractor as opposed to an employee. There are many reasons employers may wish to categorize a worker as an independent contractor vs employee, because the difference between contractor and employee may make a huge difference on the employer’s bottom line. The difference between independent contractor and employee can be a complex decision, but correctly classifying your wokers as employees or independent contractors is extremely important. Improperly classifying employees or independent contractors can result in significant problems with the IRS.
For federal tax purposes, you have to ask yourself, “is an independent contractor an employee?” While there are reasons you will not want to classify true independent contractors as employees, the most important consideration is are independent contractors employees. If workers are actually employees, not independent contractors, under federal law, you are required to withhold federal income taxes and to pay Medicare, Social Security, and unemployment taxes on all wages paid to your employees. One difference between independent contractor and employee is that you typically are not required to pay or withhold taxes on the payments you make to independent contractors. Instead, independent contractors report their income as self-employment income and pay self-employment taxes.
Determining Independent Contractor vs. Employee – The General Rule
If there is any question, it is best to consult an experience employment attorney when you are trying to classify a worker or a specific role in your company as a contractor or employee. The general rule for contractor vs employee is that if the person paying the worker has the right to direct or control merely the final result of the work in question and not how or what will be done to reach the result, the worker is likely an independent contractor. While the employee vs independent contractor question seems straight forward, it can be difficult to apply the contractor or employee label in certain situations.
When making the determination, there are three major categories that you should consider and apply to the facts of the situation to determine whether workers are employees or independent contractors:
A worker must be classified as an employee when the paying party has the right to control and direct the work that is being performed by the worker. This rule applies even in situations where the payer does not exercise the rights to control the worker. To determine whether the payer has behavioral control over the worker or not, the IRS will consider the next issues:
- The types of instructions the payer gives to the worker, including time frames and locations for work, the type or quality of tools or supplies to be used by the worker, and the location or vendor to use for the purchase of services or supplies;
- The character of the instructions given to the worker, as the less detail provided leans toward characterizing a worker as an independent contractor and more detailed instructions suggest a worker is an employee;
- Oversight of the worker, such that if the payer is merely concerned with the final product or end result, the worker is more likely an independent contract, but is more likely an employee where the payer evaluates the details of how work is completed throughout the process;
- Training, where on-going or periodic, suggests that a worker is an employee, as independent contractors more typically rely on their own skill and methods.
Another important factor considered by the IRS when determining whether an employer has properly categorized workers is whether the payer had the right to control and direct the financial aspects of the job being completed by the worker.
When conducting the analysis, the IRS may consider:
1) Expenses – employees are typically reimbursed for all expenses, while independent contractors are likely to have expenses that go unreimbursed;
2) Equipment – it is more likely that an independent contractor will make a significant financial investment in their own equipment, where an employee will typically utilize equipment owned and financed by the employee;
3) Profit or loss – an independent contractor may have opportunities for loss or profit associated with a a particular job;
4) Open market – employees typically conduct their work for a single employer, while independent contractors often market their services to multiple paying customers or clients;
5) Payment methods – independent contractors are typically paid a flat fee and may have provided an initial estimate or bid for a project at the outset, while employees are typically paid a guaranteed wage, based on the time they conduct work for the payer;
Relationship of the Parties
The third important consideration when deciding independent contractor or employee is the relationship between the payer and the worker. Depending on the industry and type of work, the relationship between employers and employees may look very different. Some of the common relevant factors that should be considered, when selecting a classification for a worker include:
1) Contracts – contracts can provide context on the type of relationship the parties intended to create at the outset of a relationships, though they are not controlling as to the proper classification of a worker;
2) Benefits – if a payer is employing benefits to a worker that are similar to those normally provided to employees, including vacation and sick pay, pension or retirement plans, and health and life insurances, it is a factor that leans heavily towards a worker being classified as an employee;
3) Duration – relationships between employers and employees are typically permanent and ongoing, while relationships between payers and independent contractors are typically limited to a single project or a series of projects;
4) Key business services – if a worker is providing business services that are central to the product or service provided by the business (such as a worker, assembling cars for a car manufacturer), then it is more likely the worker is an employee, as opposed to a worker that provides work that is not central to the product or service, provided by the business (such as a worker repairing an air conditioning unit in the car manufacturer’s plant).
If you are attempting to classify your employees, it is wise to consult an experienced employment attorney. The consequences for mischaracterizing an employee can be very expensive at both the state and federal level. An attorney can help you walk through the analysis carefully and help you defend your decisions should the IRS or other government entity challenge your classification of workers.