Independent Contractor vs. Employee: a guide to properly defining your staff’s employment status
Do I hire an independent contractor or employee? Do I need an independent contractor agreement? What’s a 1099 form and who needs to fill it out? These common questions have frustrated countless business owners over the years. It’s the holiday season, an incredibly busy season for some businesses, and an incredibly slow season for others. Many businesses hire seasonal help during this time. Today we hope to shed some light on the less-than-crystal-clear independent contractor versus employee dilemma. Whether you’re hiring additional help for the holidays or looking to implement new hiring practices and policies for the new year, this article may be valuable.
Understanding the Consequences
First, it is difficult to understand why this is a dilemma at all without understanding the consequences of classifying a new hire as an independent contractor versus an employee. The starting point for this discussion is with everyone’s favorite three letters, IRS. Once you classify a person as an employee you must adhere to federal regulations. The IRS requires you to withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to the employee. If, instead, you classify your new hire as an independent contractor you do not generally have to withhold or pay any taxes on payments to that independent contractor. An independent contractor will be subject to self-employment tax on earnings.
You’re now wondering, why would I ever classify a person as an employee if I have to withhold and pay taxes on the wages? The short answer is because the IRS, not you, has the final say on defining the employment relationships you have with your staff. If you misidentify one of your workers you may be held liable for employment taxes for that worker. Fortunately for you, there is common law and statutory guidance, albeit less-than-crystal-clear, on how to classify your employment relationship with your new hire.
The Independent Contractor
Generally an independent contractor is anyone who is in an independent trade, business, or profession and offers their services to the general public such as doctors, dentists, lawyers, accountants. Unfortunately, the analysis doesn’t stop there. Whether these people are independent contractors or employees depends on the circumstances in each situation. The general rule is that an independent contractor has control over what will be done and how it will be done, but the person paying for the services has the right to control or direct the ultimate result. For example, I can hire you as an independent contractor to build my house. I’ll tell you what I’d like the house to look like, but it’s up to you to figure out how to build the house. Under this scenario, I’ve hired you as an independent contractor.
Generally, anyone who performs services for you is your employee if you can control what will be done and how it will be done. Even when you give the employee freedom of action (e.g. you tell an employee to hammer nails into the wall but let the employee decide how to hammer the nails into the wall), the individual is still your employee because you have the legal right to control what services will be performed and ultimately, how they will be performed.
The “IRS” Statutory Employee
Here’s where things get cloudy. A worker may be an independent contractor according to the above-mentioned rules and definitions but nevertheless be treated as an employee by statute for certain employment tax purposes. If your worker falls within any one of the following four categories (as well as meet certain conditions under Social Security and Medicare taxes) they may be re-classified by the IRS as an employee:
- A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.
- A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.
- An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done.
- A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer’s business operation. The work performed for you must be the salesperson’s principal business activity.
It’s All About Control
Ultimately, whether your worker is an independent contractor or employee will come down to one thing, the degree of control you, as the employer, have over their work. To determine how much control you have over a worker, there are a number of factors to consider, including:
- Extent of control you have over the details of the work;
- Whether the occupation is generally done under direction of an employer, or by a specialist without supervision;
- The skill required by the work;
- Whether the worker supplies the tools/instruments, & the place of the work;
- The length of the employment;
- The method of payment (by time or by the job);
- Whether the work is part of the regular business of the employer;
- Whether or not the parties believe they are creating a certain relationship (i.e. each party’s subjective belief);
Businesses should consider all of these factors when determining whether a worker is an employee or independent contractor. Some factors may suggest employee, while other factors suggest independent contractor. Unfortunately, there is no clear balancing test for determining when a worker is an employee or independent contractor, and no one factor stands alone in making this determination. If you’ve considered all the factors above and are still unclear whether your worker is an employee or independent contractor you can fill out Form SS-8. The IRS will consider the facts and circumstances according to your filed form and determine the worker’s status.
When determining a worker’s employment relationship with your business, be sure to look at the entire relationship, consider the degree or extent of your right to direct and control the work, and finally, document each of the factors used in coming up with the determination. One thing is clear here, the IRS has the final say on whether the individual is an independent contractor or employee. You can, however, take the precautionary steps to ensure you have properly defined your employment relationships with your staff (and then cross your fingers the IRS agrees with you).