When you hire someone for a long-term, full-time project or a series of projects that last for an extended period, you need to understand the difference between independent contractors and employees. The Internal Revenue Service (IRS) and state regulators pay close attention to how employers categorize people who perform work for them.
Getting it Wrong Can Result in Penalties
Federal and state wage, hour, anti-discrimination, and labor laws do not apply to independent contractors. For this reason, employers sometimes prefer to categorize workers as independent contractors to avoid federal payroll taxes and unemployment and workers’ compensation expense. However, if you have determined that a worker is an independent contractor and the government determines that person is an employee, you may have to pay employment taxes and a penalty.
The Difference Between Employees and Independent Contractors
The IRS provides a process to help employers determine whether an individual is an independent contractor or an employee. It starts with understanding the relationship between the employer and the person performing services, based on the degree of control and independence in three general categories:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (These include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
The IRS goes on to say that businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Unfortunately, the IRS does not provide a general “rule of thumb” that would make this process simple. Factors that apply to one worker may not apply to another, depending on the individual work relationship. The IRS admits that “There is no ‘magic’ or set number of factors that ‘makes’ the worker an employee or an independent contractor, and no one factor stands alone in making this determination.”
Simplifying the Decision: 20 Questions
For several years, the IRS recommended using the following questions as a guideline to help employers determine whether a worker is an employee or an independent contractor. Answering these questions can help you think through the relationship you have with a worker to determine which category best describes his or her role. If you answer yes to any question, it’s likely you have an employer-employee relationship.
Instructions – Does the company direct when, where and how to complete the work?
Training – Does the job require training? Do you require the person to receive training from the company or from a company-provided trainer?
Business Integration – Are the worker’s services integrated with company activities? Does the company’s business success depend in part on the worker’s services?
Personal Services – Do you require the individual to personally perform the work? Independent contractors usually may assign work to others.
Ability to hire, supervise and pay assistants – Does your company retain the right to hire, supervise and pay assistants to the worker? If the worker may engage others outside your company to assist, typically that describes an independent contractor relationship.
Continuing Relationship – Does the worker have a continuing relationship with the employer?
Flexibility of Work Hours – Does the company dictate the hours or days of work?
Full-Time Work Required – Do you require the worker to work full time at your company?
Place of Work – Do you require the work to be done on your premises, using your equipment?
Sequence of Work – Do you require the worker to perform the work in a specific order or sequence?
Requirements for Reports – Do you require the worker to provide regular written or oral reports regarding project status?
Method of Payment – Do you pay the worker according to a regular schedule, such as hourly, weekly or monthly?
Payment of Business or Travel Expenses – Do you reimburse the worker for business or travel expenses? Independent contractors typically cover these items in their fee structure.
Tools and Materials – Do you provide tools and materials for the worker to perform most of the work? Independent contractors typically provide their own tools and materials.
Facility Investment – Does the worker rely on your company for work facilities? Independent contractors usually provide their own work facilities.
Profit or Loss – Do you pay the worker predetermined earnings, regardless of the profit or loss of the company?
Work for One Company at a Time – Does the worker work for only one company at the same time? Independent contractors typically can perform work for multiple companies.
Availability of Service to the General Public – Does the worker provide service only for your company, without the opportunity to seek additional work from the general public?
Right to Discharge – Can you fire the worker unilaterally? Independent contractors may have contractual terms regarding discharge.
Right to Quit – Can the worker quit working for you without liability? Most employees can do this. Independent contractor rights may be covered by a contract, potentially limiting the right to quit.
Minimize Your Misclassification Risk
If you misclassify an employee as an independent contractor, you may end up before a state taxing authority or the IRS. In order to reduce the risk of an investigation or challenge by a state or federal authority, you should, at a minimum:
- Familiarize yourself with the rules. Ignorance of the rules is not a legitimate defense. Knowing rules will allow you to structure and carefully manage your relationships with your workers to minimize risk.
- Document relationships with your workers and vendors. Although it won’t always save you, having a written contract stating the terms of employment can help.
Working through the details on employee classification can be complicated and possibly even intimidating. It helps to have a tax professional working side-by-side with you on something this important to your business. If we can be of any assistance in this or any other accounting-related issue, please contact your TD&T professionals. We’re more than happy to answer questions and work through issues like this to help your business succeed and prosper.