Contractor or Employee?

Written by Shelley B. Drevas, CPA

Whether a worker is classified as an independent contractor or an employee greatly affects the taxes and other costs a small business owner must pay.

It benefits a small businesses to classify workers as contractors because the businesses don’t have to withhold federal, state and Social Security taxes, or pay unemployment taxes, workers compensation insurance or other benefits. On the other hand, U.S. government agencies such as the IRS, the Department of Labor and the Social Security Administration, as well as various state tax and labor agencies, lose revenues when workers are misclassified. And workers incorrectly classified pay more taxes than they should and could lose out on benefits.

The IRS has developed 20 common-law guidelines for determining whether a worker is an independent contractor or employee. Generally, the IRS looks at how much control the company has over the worker and at how both parties see their relationship. These are not hard and fast rules, but are merely guidelines. Classification does not depend on one single factor. Some factors carry greater weight and some depend on the industry, so many considerations must be made on a case-by-case basis. The factors are:

Instructions – how much direction a worker receives from the company about when, where and how the job is done.
Training – can be in serveral forms, including formal training, working with an experienced employee of the company, being required to attend meetings, etc.
Integration – how much the worker’s performance contributes to the continuation of the business.
Services Rendered Personally – whether the services can be rendered only by the worker or if someone else designated by the worker could perform the job.
Hiring, Supervising and Paying Assistants – whether the company has control over whom the worker can hire as assistants, and whether the worker or the company pays assistants.
Continuing Relationship – whether there is a continuing relationship between the worker and the company. This could occur even if the work is performed irregularly.
Set Hours of Work – whether work is to be performed during certain hours of business or if the worker is able to set his or her own hours.
Full Time Required – whether the worker is required to work a number of hours equivalent to full-time employment and is restricted from performing other gainful work.
Doing Work on Employer’s Premises – the importance of where the work is done depends on the nature of the services and the general practices of the company and its industry. If a worker is off the premises but is still required to work at a specific place or on a specific route, there is still an assumption of significant control.
Order or Sequence Set – whether the worker is required to work in a specific sequence rather than in his or her own way. Furthermore, even if the employer does not require such order or sequence but retains the right to do so, there is still an assumption of significant control.
Oral or Written Reports – A degree of control is assumed if the worker is required to submit periodic oral or written reports to the company.
Payment Terms – If payment is to be made on an hourly, weekly or monthly basis, an employer-employee relationship is generally assumed, even when supplemented by a commission; but if this arrangement is merely a more convenient way to pay a lump-sum agreed-upon price, there is no assumption of financial control.
Payment of Business or Traveling Expenses – whether the company pays any or all of the worker’s business expenses or traveling expenses, or both. Also considered are costs that are fixed and incurred by the worker regardless of whether the work is currently being performed.
Furnishing Tools or Materials – whether the company furnishes tools and materials for the worker. Incidental use of tools and materials might not necessarily create a controlling relationship.
Significant Investment – An employee generally performs services at a facility provided by the employer. An independent contractor often invests in facilities in which he or she either provides services or does administrative work.
Realization of Profit or Loss – whether the worker is at substantial risk of loss in connection with performing his or her services.
Working for More Than One Company at a Time – An employee generally works for only one company, while an independent contractor is free to work for multiple unrelated persons.
Making Service Available to the General Public – whether it is generally known in the community that the worker is an independent contractor seeking other business opportunities (through advertisements, marketing, etc.), or whether the worker describes himself or herself as an employee of the company.
Right to Discharge – Whether the company maintains control over a worker’s job performance through the threat of dismissal. An independent contractor generally cannot be dismissed, as long as he or she obtains the expected results as agreed upon with the company.
Right to Terminate – An employee generally has the right to terminate his or her employment at any time without incurring any liability. A contractor must adhere to the terms of the contract, or face possible legal ramifications.

Since many of these factors are subjective and are not clearly defined, all relationships between companies and independent contractors should be documented as much as possible. The business and contractor should have a written agreement signed by both parties, stating that he or she is an independent contractor and spelling out the terms of the contract. The contractor should send bills to the business at regular intervals, should carry his or her own insurance (health, liability, workers compensation), and should provide the tools, materials, training, transportation and other necessities for performing his or her duties. It is also vital for the company to give the contractor as much independence as possible so as to not show significant control in the areas mentioned previously.

If, after applying the above tests, the classification of a worker is still unclear, you can ask the IRS to decide. File Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS to receive a determination.

Knowing the proper worker classification can be critical to a small business. Misclassification and poor documentation could result in the additional costs associated with an audit. If the IRS determines that the company has misclassified its workers, the company could be required to pay all back-withholding and employment taxes, plus interest. This is true even if the worker had already paid taxes on this income. The IRS could also assess penalties and even press criminal charges. IRS audit findings could also open the door for other federal and state agencies. Furthermore, misclassified independent contractors have successfully sued for such things as the unemployment insurance, overtime pay and benefits they should have received if they been properly classified as employees.