Some business owners adopt a strategy of hiring independent contractors to perform services rather than employees. While there are some savings to adopting such a strategy there are also some significant risks if you misclassify the relationship. If you hire someone for a long-term, full-time project or a series of projects that are likely to last for an extended period, you must pay special attention to the difference between independent contractors and employees.
Why It Matters
The Internal Revenue Service and state regulators scrutinize the distinction between employees and independent contractors because many business owners try to categorize as many of their workers as possible as independent contractors rather than as employees. They do this because independent contractors are not covered by unemployment and workers’ compensation, or by federal and state wage, hour, anti-discrimination, and labor laws. In addition, businesses do not have to pay federal payroll taxes on amounts paid to independent contractors or provide fringe benefits to these individuals. If you incorrectly classify an employee as an independent contractor, you can be held liable for employment taxes for that worker, plus a penalty! In addition, there are other less obvious pitfalls such as disqualification of your retirement plan and potential civil litigation to deal with.
The Difference Between Employees and Independent Contractors
Independent Contractors are individuals who contract with a business to perform a specific project or set of projects. You, the payer, have the right to control or direct the result of the work done by an independent contractor, and not the means and methods of accomplishing the result.
Employees provide work in an ongoing, structured basis. In general, anyone who performs services for you is your employee if you can control what will be done and how it will be done. A worker is still considered an employee even when you give them freedom of action. What matters is that you have the right to control the details of how the services are performed.
Independent Contractor Qualification Checklist
The IRS, workers’ compensation boards, unemployment compensation boards, federal agencies, and even courts all have slightly different definitions of what an independent contractor is though their means of categorizing workers as independent contractors are similar.
One of the most prevalent approaches used to categorize a worker as either an employee or independent contractor is the analysis created by the IRS, which considers the following:
- 1. What instructions the employer gives the worker about when, where, and how to work.
The more specific the instructions and the more control exercised, the more likely the worker will be considered an employee.
- 2. What training the employer gives the worker. Independent contractors generally do not receive training from an employer.
- 3. The extent to which the worker has business expenses that are not reimbursed. Independent contractors are more likely to have unreimbursed expenses.
- 4. The extent of the worker’s investment in the worker’s own business. Independent contractors typically invest their own money in equipment or facilities.
- 5. The extent to which the worker makes services available to other employers. Independent contractors are more likely to make their services available to other employers.
- 6. How the business pays the worker. An employee is generally paid by the hour, week, or month. An independent contractor is usually paid by the job.
- 7. The extent to which the worker can make a profit or incur a loss. An independent contractor can make a profit or loss, but an employee does not.
- 8. Whether there are written contracts describing the relationship the parties intended to create. Independent contractors generally sign written contracts or work orders that specifies the project or service. These agreements should also state they are independent contractors.
- 9. Whether the business provides the worker with employee benefits, such as insurance, a pension plan, vacation pay, or sick pay. Independent contractors generally do not get benefits.
- 10. The terms of the working relationship. An employee generally is employed at will (meaning the relationship can be terminated by either party at any time). An independent contractor is usually hired for a set period of time or for a project or service.
- 11. Whether the worker’s services are a key aspect of the company’s regular business. If the services are necessary for regular business activity, it is more likely that the employer has the right to direct and control the worker’s activities. The more control an employer exerts over a worker, the more likely it is that the worker will be considered an employee.
Minimize the Risk of Misclassification
If you misclassify an employee as an independent contractor, you may end up before a state taxing authority or the IRS.
Sometimes the issue comes up when a terminated worker files for unemployment benefits and it’s unclear whether the worker was an independent contractor or employee. The filing can trigger state or federal investigations that can cost many thousands of dollars to defend, even if you successfully fight the challenge.
There are ways to reduce the risk of an investigation or challenge by a state or federal authority. At a minimum, you should:
- • Familiarize yourself with the rules. Ignorance of the rules is not a legitimate defense. Knowledge of the 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, it helps to have a written contract stating the terms of employment.
- • Seek counsel from professional advisors as this is a complex area and can have significant subjective criteria in making the determination.
If you would like more information on classifying workers, please contact us today.