Employee or Contractor? 10 Ways to Make This Important Distinction
Are your workers employees or independent contractors? It pays to know the difference.
Independent contractors often provide a convenient and economical way for small businesses to increase their bandwidth. Compared with adding a full- or part-time employee, outsourcing the work to a contractor is generally cheaper and less of a hassle because the business does not have to pay and withhold payroll taxes, pay unemployment insurance, or provide benefits for contractors.
The IRS wants to make sure businesses don’t take advantage of these benefits by incorrectly classifying employees as independent contractors. If the IRS determines that you have done so, you will owe not only the employer’s share of the payroll taxes, but also the employee’s share, interest, and possibly a penalty. All told, you could be hit with a bill of 15% to 20% of the worker’s wages, not to mention the hassle of filing an amended return.
While there is no black-and-white rule for making the distinction, generally speaking, the more control you have over the worker, the more likely that the worker is an employee. The IRS provides 10 guidelines to help determine whether a worker is an employee or a contractor, and these guidelines are organized into three groups: behavioral control, financial control, and type of relationship.
Behavioral control: This group of tests determines the extent to which the business controls what the worker does and how the worker does it.
Instructions given to the worker: An employee is generally subject to the business’s instructions about when, where, and how to perform the work. This could include instructions regarding what equipment to use or the sequence of steps to follow. A contractor, on the other hand, is generally told what the finished product should look like, but then given freedom to decide how it should be accomplished.
Training given to the worker: An employee is likely trained by the company to perform a task in a specified manner; a contractor ordinarily uses his or her own methods.
Financial control: This group of tests determines the extent to which the business has control over the worker’s profitability and financial situation.
Work-related expenses: Independent contractors are more likely to have unreimbursed expenses than are employees; this is especially true for fixed, ongoing costs that are incurred regardless of whether work is currently being performed. Employees may occasionally incur unreimbursed expenses in connection with their job, just not as often as contractors do.
Worker’s investment: An employee usually has no investment in the work other than his or her own time. A contractor often has a significant investment in the facilities and equipment used in performing the services. This may include computers, phones, and software.
Marketability of services: Unlike an employee, a contractor is generally free to seek out other business opportunities in the relevant marketplace. Contractors often market their services by advertising and/or maintaining a visible business location.
Type of payment: An employee is generally guaranteed an annual salary or a regular wage for an hourly, weekly, or other period of time. The employee’s wage or salary might also be supplemented by a commission. A contractor, on the other hand, is usually paid a flat fee for the job. In some fields, such as law, however, it is common to pay independent contractors hourly.
Opportunity to sustain a loss: Employees generally do not have the risk of sustaining a loss for the work. This is because the company usually provides employees the equipment and other resources needed to do the work and generally pays the costs of doing business. A contractor, however, can either make a profit or loss for the project.
Type of relationship: These tests look at the contractual nature and permanency of the work, as well as the availability of benefits.
Permanency of the relationship: Employees are generally engaged with the expectation that the relationship will continue indefinitely. Contractors are generally engaged for a specific project or time period.
Availability of benefits: Employees often—but not always—are provided benefits such as vacation time, health insurance, and retirement benefits, as part of the total compensation. Contractors do not receive these benefits and must finance these expenses out of the overall profits of the enterprise.
“Essentialness” of the work: If a worker provides services that are a key aspect of the company’s regular business activity, it is more likely that the worker is an employee. For example, if a law firm hires an attorney, it is likely that the firm 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.
It is important to keep in mind that these are just guidelines, and there is no single measure that makes the ultimate determination. In fact, in many cases the work relationship has some characteristics of an employee and other characteristics of an independent contractor. Further complicating things, a relationship that the IRS determines is an employee in one field may be determined to be a contractor in a different field. Each situation requires careful consideration.
At Eilts & Associates, we have helped small businesses in a wide range of fields properly classify their workers and maximize the tax benefits of the different work arrangements. We are available to guide you through the employee-vs.-contractor classification process.
I hope this information is helpful. If you have any questions please contact Bart Eilts at 773-525-6171 or bart@eiltscpa.com.
