Self-Employment Guide: Employees vs. Independent Contractors
The employee vs. independent contractor debate continues to be a hot topic, with the IRS cracking down in recent years on employers who have wrongfully classified their workers. This is why, if you’re a business owner, it’s important to know the distinction between employees and independent contractors. Typically, employers are required to withhold income tax, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages for employees. Independent contractors, however, require fewer tax forms, and are generally not expected to receive benefits or tax withholding payments from those employing them.
So, properly classifying those working for you is key, and correctly distinguishing someone you hire as an independent contractor can save your business substantial money and benefits, and can greatly decrease your tax obligations. Incorrectly classifying a worker, whether intentionally or unintentionally, can lead to penalties and unnecessary expenses, so it’s essential to pay attention to the details when hiring and throughout the employment period.
While there is no standardized, established test in place for determining whether a worker should be classified as an employee versus an independent contractor, there are a number of key identifiers that can be used to make the determination.
CONTROL & INDEPENDENCE
The main factor in play when a distinction is being made between employee and independent contractor is the level of control and independence with the service or work being performed. In other words, the “substance” or nature of the relationship between the person providing services and the person for whom those services are being provided, ultimately determines which classification the worker falls within. If you, the business owner, have control of the means, methods, and result of the work being performed, the person working for you is considered an employee. On the other hand, if you have control only over the final product or result of the work being done, but have no control over the way the work is done or what methods are used to complete it, the person performing the services is considered an independent contractor.
This may seem straightforward, but there are many factors and minute details to keep in mind when faced with this distinction. Any and all information that provides evidence of the degree of control and independence must be considered and reviewed at length. These facts fall into three main categories: (1) behavioral control, (2) financial control, and (3) the type of relationship between the two parties.
The behavioral control factors include type of instructions given, degree of instruction, evaluation systems, and training. If the worker is an employee, he or she is usually subject to the business/employer’s instructions related to when, where, and how to work, what tools or equipment should be used, who should and can assist with work, what work must be performed by whom, and what sequence to follow when performing the work.
With regards to degrees of instruction, the general assumption is that the more detailed the instructions are, the more control the employer or business exercises over the worker. More detailed instructions indicate that the worker is an employee, while less detailed or open-ended instructions indicate an independent contractor.
If there is an evaluation system in place to measure the details of how the work is performed, this points to an employee classification. If the evaluation system measures only the end result, however, the worker could be an employee or an independent contractor depending on the other factors of distinction.
If the business provides the worker with training on how to do the job, this indicates that the business or employer 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. Independent contractors, on the other hand, typically use their own methods.
The factors relating to financial control include considerations such as significant investment, unreimbursed job expenses, opportunity for profit or loss, services available to the market, and method of payment. As far as the investment factor, independent contractors generally have a lot of time and money invested in the work they are performing.
Independent contractors are also more likely to incur unreimbursed expenses related to the work being done, while employees are more often reimbursed for expenses incurred on the job. The profit and loss factor relates to whether the worker could incur a loss related to the work. If a loss can be incurred, this indicates that the worker is an independent contractor.
The type of relationship factors include written contracts, employee benefits, permanent versus temporary nature of the relationship, and services provided as a key activity of the business. Benefits might include insurance, pensions, paid time off, sick and vacation days, and flex spending accounts. Benefits are typically offered to employees, and not to independent contractors. Written contracts are often put in place to clearly identify the relationship between the two parties by describing how they will work together.
With the IRS tightening up on these classifications lately, it’s imperative for business owners to understand the potential consequences of wrongfully classifying an employee. If you classify an employee as an independent contractor without having reasonable basis for doing so, you may be held liable for employment taxes for that worker as well as additional penalties and fees depending on the degree of the offense and whether it’s seen as intentional.
The IRS can be a useful resource for guides and questionnaires that help business owners and employers ask the right questions and make educated designations. IRS Form SS-8 can also be used to request a determination of an individual’s status as employee or contractor.
It is important to keep in mind, as well, that an IRS classification of a worker as an independent contractor rather than an employee does not necessarily mean that that classification will be accepted by other governmental offices such as the Department of Labor. That’s why it’s key to pay close attention to all the factors present within the functions of your business and make careful decisions when hiring and running your company.
Should you have any questions about making the distinction between employee and independent contractor, or our services, please contact us at firstname.lastname@example.org or (212) 245-5900.
John Gontijo, CPA, MBA, has been at FF&F as a Senior Tax Accountant for 4 years. He has over 10 years of experience with high net worth individuals, small businesses, and international taxation. Prior to joining FF&F, he worked for a niche CPA firm in NYC which specialized in inbound U.S. tax matters for German, Swiss, and Austrian clients, including Offshore Voluntary Disclosure Programs.