You’re in business for yourself and you need people to work for you. But you might not need them full time. Or, you’re thinking that you just don’t want to go to the trouble of having employees and the expense of paying payroll taxes. So you wonder if you can hire a bookkeeper or a maintenance guy or some other type of help and pay them as an independent contractor.
My advice? In most cases, don’t do it.
What’s the Difference?
Having employees involves not only payroll taxes but also payroll tax withholding, minimum wage considerations and overtime pay, providing meal periods or rest breaks, workers’ compensation insurance and unemployment insurance. But working with an independence contractor involves none of those things. So working with independent contractors can be easier and less expensive than having employees and the lure to do that is strong.
Both the IRS and the state you do business in have guidelines for determining the difference between an employer-employee relationship and an independent contractor relationship. State guidelines are generally in line with the IRS’s but can have some differences. For the purposes of this post, I will focus on the IRS’s guidelines.
Basically, an employee is someone whose work efforts you control as the employer for an indefinite period of time. An independent contractor is someone who performs specific work with a defined time line whose efforts you don’t control.
IRS Guidelines
It is the courts that decide if a worker is an independent contractor or an employee. They consider many facts when making a determination. But the relevant facts fall into three main categories:
- Behavioral Control
- Financial Control
- Relationship of the Parties
As you can see, the issue of control is primary in determining the true nature of the relationship.
Behavioral control is the right to direct or control how the worker does the work. This can include control over what tools or equipment are used, what supplies or services will be used, and what order the work will be done in. If the employer typically instructs the worker on when, where and how to do the work, then an employer-employee relationship is indicated. Independent contracts typically use their own tools and set their own work schedules.
If the employer provides a worker with training on required procedures and methods for how the service is to be performed then this would indicate that the employer wants the work done in a specific way and this would suggest an employer-employee relationship. Independent contractors typically use their own methods to get the work done.
So, if you engage a bookkeeper but require that she work specific times on specific days of the week and she always comes in and uses your computer, then she most likely would be considered an employee.
Financial control is about who has the opportunity for profit or loss and whether the worker receives reimbursement for business expenses. It also involves how the rate of pay is determined and how payment is actually made to the worker.
Typically, an independent contractor can realize a profit or loss as a result of the work that is done for the employer because he has control over the costs associated with the work; an employee does not. Independent contractors generally have fixed ongoing costs associated with being in business that are not reimbursed by the employer. In an employer-employee relationship, the worker incurs very little if any expenses in connection with the service being performed for the employer and these costs are usually reimbursed.
Employees are typically guaranteed an hourly wage or salary set by the employer and paid at specific and regular time intervals. Although an independent contractor may also be paid an hourly rate, the rate is typically determined by the contractor based on usual and customary rates in the industry and it is billed to the employer by the contractor at times established by the contractor.
Thus, if you hire a person to clean your offices but pay for all of the cleaning supplies and pay him minimum wage by the hour every two weeks, then it is very likely that he would be considered an employee.
Relationship of the parties refers to the facts and circumstances that illustrate how the employer and the worker perceive their relationship. For example, requiring a written contract can be important in establishing the intent of an independent contractor relationship. If you hire a worker for an indefinite period of time rather than for a specific project or a set amount of time, then this would generally indicate that your intent was to create an employer-employee relationship.
The Independent Contractor
A true independent contractor is a person who:
- Has his or her own business name and business licenses
- Solicits work from and does in fact work for other customers
- May have his own place of business and invests in equipment and supplies
- Uses business cards and his own website
- Carries insurance
- Sets their own schedule
- Sets or negotiations their own rate of pay
- Submits an invoice or bill when payment is due
- Pays his own expenses and assumes the risk for profit or loss
These are people who perform an independent trade or have an independent business and offer their services to the general public. As the employer, you can control or direct the results of their work but not the means and methods by which they perform it.
The distinction between the employer-employee relationship and the independent contractor relationship depends primarily on the level of supervision, direction and control exercised by the person engaging the services. It is not defined by what the relationship is called by the participants.
The Consequences
If you incorrectly classify and pay an employee as an independent contractor, you could find yourself liable for payment of back employment taxes for the worker. This includes not only the employer’s share but also the employee’s share of social security and Medicare taxes that should have been withheld from their paychecks as well as unemployment insurance. And, you may be required to pay back overtime pay. Additionally, you could face penalties for failing to pay employment taxes and for failing to file required tax forms. And, you could face this on both a federal and a state level. The cost to your company could be astronomical.
When in Doubt
IRS Publication 15-A, Employer’s Supplemental Tax Guide, contains a number of industry examples that may help you determine the proper classification of a worker.
But if you’re really not sure if a particular employment arrangement constitutes employee or independent contractor status, you can file Form SS-8 with the IRS to request a determination of worker status.