The question of whether someone who works for you is an employee (you control the details of what will be done and how it will be done) or an independent contractor (you are self-employed and provide services to other businesses) has important tax and legal consequences. If you have employees, you have liability to pay and withhold Federal income tax, social security and Medicare taxes, and Federal unemployment tax, report wages and issue statements to employees. For independent contractors, generally no withholding is required.
The IRS has recently ‘simplified’ their IRS Independent Contractor Test (down from 20 factors) to eleven main tests, organized into three main groups: behavioral control, financial control, and the type of relationships between the parties.
Businesses must weigh all of the following factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. 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. Also, factors which are relevant in one situation may not be relevant in another.
The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.
Refers to facts that show whether there is a right to direct or control how the worker does the work. A worker is an employee when the business has the right to direct and control the worker. The business does not have to actually direct or control the way the work is done – as long as the employer has the right to direct and control the work. The following factors apply:
Types of Instructions Given. An employee is generally subject to the business’s instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work.
- When and where to do the work.
- What tools or equipment to use.
- What workers to hire or to assist with the work.
- Where to purchase supplies and services.
- What work must be performed by a specified individual.
- What order or sequence to follow when performing the work.
Degree of Instruction means that the more detailed the instructions, the more control the business exercises over the worker. More detailed instructions indicate that the worker is an employee. Less detailed instructions reflects less control, indicating that the worker is more likely an independent contractor.
Note: The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker’s performance or instead has given up that right.
If an Evaluation System measures the details of how the work is performed, then these factors would point to an employee. If the evaluation system measures just the end result, then this can point to either an independent contractor or an employee.
If the business provides the worker with Training on how to do the job, this indicates that the business wants the job done in a particular way. This is strong evidence that the worker is an employee. Periodic or on-going training about procedures and methods is even stronger evidence of an employer-employee relationship. However, independent contractors ordinarily use their own methods.
Refers to facts that show whether or not the business has the right to control the economic aspects of the worker’s job.
An independent contractor often has a Significant Investment in the equipment he or she uses in working for someone else. However, in many occupations, such as construction, workers spend thousands of dollars on the tools and equipment they use and are still considered to be employees. There are no precise dollar limits that must be met in order to have a significant investment. Furthermore, a significant investment is not necessary for independent contractor status as some types of work simply do not require large expenditures.
Independent contractors are more likely to have Unreimbursed Expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform for their business.
The Opportunity to Make a Profit or Loss is another important factor. If a worker has a significant investment in the tools and equipment used and if the worker has unreimbursed expenses, the worker has a greater opportunity to lose money (i.e., their expenses will exceed their income from the work). Having the possibility of incurring a loss indicates that the worker is an independent contractor.
An independent contractor is generally free to seek out business opportunities and make their Services Available to the Market. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.
Method of Payment. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.
Type of Relationship
Refers to facts that show how the worker and business perceive their relationship to each other.
Although a Written Contract may state that the worker is an employee or an independent contractor, this is not sufficient to determine the worker’s status. The IRS is not required to follow a contract stating that the worker is an independent contractor, responsible for paying his or her own self-employment tax. How the parties work together determines whether the worker is an employee or an independent contractor.
Employee Benefits include things like insurance, pension plans, paid vacation, sick days, and disability insurance. Businesses generally do not grant these benefits to independent contractors. However, the lack of these types of benefits does not necessarily mean the worker is an independent contractor.
Permanency of the Relationship. If you hire a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.
If a worker Provides Services That are a Key Aspect of the Business, it is more likely that the business will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.
Consequences of Treating an Employee as an Independent Contractor
Whether intentional or unintentional, misclassification of employees as independent contractors is a serious issue, and could cost your company a lot of money in the form of IRS/State audits, Department of Labor investigations, paying back wages and overtime owed, payroll taxes, lost benefits, plus penalties, interest, hefty fines, other damages, negative exposure, and often legal fees.
If you’re unsure how to classify an employee, I recommend you consult with an HR professional so you save time, money and certainly unintended consequences in the long run.