Determining whether your current staff and next hires are employees or independent contractors is not an exact science. We can help clarify this determination by explaining the tests that will help you decide whether a worker is an employee or an independent contractor and the implications of both.
Why Does Classification Matter?
Knowing if you have an employee or an independent contractor is important for a variety of business and compliance issues. Many business issues such as Federal and state taxes, employee benefits, ERISA compliance, and civil liability, hinge on whether or not a person is an employee or an independent contractor. For example, generally, your company is responsible for any liabilities caused by an employee, but not by an independent contractor. Likewise, for employees, your company is responsible for paying the employer portion of Social Security, Medicare and sometimes state unemployment taxes.
Misclassifying a worker can lead to a host of unwanted issues including penalties, taxes and fees. Therefore, knowing whether a worker is an employee or independent contract is important. Additionally, knowing these tests can help you properly classify a worker in the beginning of your relationship avoiding any repercussions of misclassification.
How Do You Know?
Three major categories are used to help determine the difference between an employee and an independent contractor: (1) behavioral factors, (2) financial factors, and (3) the nature of the relationship. No one factor is dispositive; instead, it is a weighing of several points in each category.
Behavioral factors include the type and degree of instructions given, the measure used to determine a completed job, and the amount and duration of training. The more instructions and the more details given, the more likely the worker is to be classified as an employee. If you tell the worker when and where to do the work, which equipment or tools to use, where to purchase any supplies, what steps to take to complete the work, and which people should perform which tasks, then most likely this is an employee. The key factor is determining if the business has the right to control the details of the worker’s performance, even if little or no instruction is necessary.
How you evaluate the job after completion is also a factor. If you measure how the work was done, instead of the end result, this evaluation system suggests you have an employee. Training the worker on how to do the job also suggests that a worker is an employee, particularly if you have continual training or more than one training session.
Financial factors tend to be a little trickier to evaluate because these factors cannot be applied across all types of services. For example, one factor that tends to show that a worker is an independent contractor is significant investment in the tools or equipment that the worker uses. However, this factor is not quantifiable; meaning, no dollar minimum qualifies as a “significant investment”. Additionally, some jobs, particularly in construction, where a worker buys his own tools, are still classified as employee positions.
Other financial factors that suggest a worker is an independent contractor are (1) unreimbursed expenses, (2) opportunity for profit or loss, (3) ability to seek out other business opportunities in the market, and (4) payment based on a flat fee per job, rather than payment on an hourly or salary basis. For example, independent contractors will typically have their own overhead costs, such as tools, equipment, insurance and other unreimbursed expenses. Thus, an independent contractor has the potential to lose money on a job; while an employee does not have this same risk.
Nature of the Relationship
The nature of the relationship refers to the interactions between the worker and the employer. Several factors can be weighed to determine the nature of the relationship, such as written employment contracts, employee benefits, the permanency of the relationship and whether or not the services provided are a key activity of the business. A written contract outlining the worker’s expectations and duties is helpful for making a determination on the type of worker; however, if your company has a worker that meets all of the factors for an employee, you cannot call them an independent contractor in their contract to avoid the employee classification. Likewise, if your company provides the worker with vacation pay, health insurance and a retirement plan, you are suggesting that the relationship will be ongoing, rather than specific to a project or predetermined period. Not providing workers with benefits does not mean they are independent contractors rather than employees.
You should also evaluate the services that the worker provides to your business. If the services are a key aspect of your business, this suggests the worker is an employee. For example, if you own a painting company and hired a worker to work at your office, answer phones calls, book appointments, handle client complaints and reorder office supplies, then this individual is an employee. On the other hand, if the computer system failed and you hired somebody to repair the system, you likely hired an independent contractor. The first worker is necessary on a long term basis to make sure that the company’s primary business runs smoothly, while the second worker is needed to complete a one-time project.
No one factor will determine a worker’s status and no specific number of factors will automatically classify a worker as an employee or independent contractor. Instead, evaluate each factor as a piece of the whole and look at the entire employment relationship. If after careful evaluation you are still unsure of a worker’s status, for tax purposes, you can seek a determination from the IRS using Form SS-8, available at the IRS. A determination from the IRS can be a lengthy process.
In addition to independent contractor and employee classifications, for tax purposes, workers have additional classifications for statutory employees and statutory nonemployees.