Employee vs. Contractor

It is very important that small business understand and correctly apply the rules for classifying a worker as an employee or an independent contractor. For federal employment tax purposes, a business must examine the relationship between itself and the worker.

Worker Classification is important because it determines if an employer must withhold income taxes and pay Social Security, Medicare taxes and unemployment tax on wages paid to an employee. Businesses normally do not have to withhold or pay any taxes on payments to independent contractors. The earnings of a person working as an independent contractor are subject to self-employment tax.

The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done. Small businesses should consider all evidence of the degree of control and independence in the employer/worker relationship. Whether a workers is an independent contractor or employee depends on the facts and circumstances in each situation.

how to classify a worker

To better determine how to properly classify a worker, consider these three categories – Behavioral Control, Financial Control and Relationship of the Parties.

Behavioral Control: A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. Behavioral control categories are:

Type of instructions given, such as when and where to work, what tools to use or where to purchase supplies and services. Receiving the types of instructions in these examples may indicate a worker is an employee.
Degree of instruction, more detailed instructions may indicate that the worker is an employee. Less detailed instructions reflects less control, indicating that the worker is more likely an independent contractor.
Evaluation systems to measure the details of how the work is done points to an employee. Evaluation systems measuring just the end result point to either an independent contractor or an employee.
Training a worker on how to do the job -- or periodic or on-going training about procedures and methods -- is strong evidence that the worker is an employee. Independent contractors ordinarily use their own methods.

Financial Control: Does the business have a right to direct or control the financial and business aspects of the worker's job? Consider:

Significant investment in the equipment the worker uses in working for someone else.
Unreimbursed expenses, independent contractors are more likely to incur unreimbursed expenses than employees.
Opportunity for profit or loss is often an indicator of an independent contractor.
Services available to the market. Independent contractors are generally free to seek out business opportunities.
Method of payment. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time even when supplemented by a commission. However, independent contractors are most often paid for the job by a flat fee.

Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. This includes:

Written contracts which describe the relationship the parties intend to create. Although a contract stating the worker is an employee or an independent contractor is not sufficient to determine the worker’s status.
Benefits. Businesses providing employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay have employees. Businesses generally do not grant these benefits to independent contractors.
The permanency of the relationship is important. An expectation that the relationship will continue indefinitely, rather than for a specific project or period, is generally seen as evidence that the intent was to create an employer-employee relationship.
Services provided which are a key activity of the business. The extent to which services performed by the worker are seen as a key aspect of the regular business of the company.

consequences of misclassifying an employee

Classifying an employee as an independent contractor with no reasonable basis for doing so makes employers liable for employment taxes. Certain employers that can provide a reasonable basis for not treating a worker as an employee may have the opportunity to avoid paying employment taxes. See Publication 1976, Section 530, Employment Tax Relief Requirements for more information.

In addition, the Voluntary Classification Settlement Program, offers certain eligible businesses the option to reclassify their workers as employees with partial relief from federal employment taxes.

Use Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding to help determine the status of a worker. IRS Publication 15-A, Employer's Supplemental Tax Guide, is also an excellent resource.

Workers who believe an employer improperly classified them as independent contractors can use Form 8919 to figure and report the employee’s share of uncollected Social Security and Medicare taxes due on their compensation.

INDEPENDENT CONTRACTOR OR EMPLOYEE FACTOR TEST

A worker does not have to meet all 20 criteria to qualify as an employee or independent contractor, and no single factor is decisive in determining a worker's status. The individual circumstances of each case determine the weight IRS assigns different factors.

Employers uncertain about how to classify a worker can request an IRS determination by filing Form SS-8, “Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” Some tax specialists caution that IRS usually classifies workers as employees whenever their status is not clear and, employers that request an IRS determination lose certain protections against liability for misclassification.

FACTORS USED TO EVALUATE THE RIGHT TO CONTROL

LEVEL OF INSTSRUCTIONS

If the company directs when, where, and how work is done, this control indicates a possible employment relationship.

AMOUNT OF TRAINING

Requesting workers to undergo company-provided training suggests an employment relationship since the company is directing the methods by which work is accomplished.

DEGREE OF BUSINESS INTEGRATION

Workers whose services are integrated into business operations or significantly affect business success are likely to be considered employees.

EXTENT OF PERSONAL SERVICES

Companies that insist on a particular person performing the work assert a degree of control that suggests an employment relationship. In contrast, independent contractors typically are free to assign work to anyone.

CONTROL OF ASSISTANCE

If a company hires, supervises, and pays a worker's assistants, this control indicates a possible employment relationship. If the worker retains control over hiring, supervising, and paying helpers, this arrangement suggests an independent contractor relationship.

CONTINUITY OF THE RELATIONSHIP

A continuous relationship between a company and a worker indicates a possible employment relationship. However, an independent contractor arrangement can involve an ongoing relationship for multiple, sequential projects.

FLEXIBILITY OF SCHEDULE

People whose hours or days of work are dictated by a company are apt to qualify as its employees.

DEMAND FOR FULLTIME WORK

Full-time work gives a company control over most of a person's time, which supports a finding of an employment relationship.

NEED FOR ON-SITE SERVICES

Requiring someone to work on company premises— particularly if the work can be performed elsewhere—indicates a possible employment relationship.

SEQUENCES OF WORK

If a company requires work to be performed in specific order or sequence, this control suggests an employment relationship.

REQUIREMENTS OF REPORT

If a worker regularly must provide written or oral reports on the status of a project, this arrangement indicates a possible employment relationship.

METHOD OF PAYMENTS

Hourly, weekly, or monthly pay schedules are characteristic of employment relationships, unless the payments simply are a convenient way of distributing a lump-sum fee. Payment on commission or project completion is more characteristic of independent contractor relationships.

PAYMENT OF BUSINESS TRAVEL EXPENSES

Independent contractors typically bear the cost of travel or business expenses, and most contractors set their fees high enough to cover these costs. Direct reimbursement of travel and other business costs by a company suggests an employment relationship.

PROVISIONS OF TOOLS AND MATERIALS

Workers who perform most of their work using company-provided equipment, tools, and materials are more likely to be considered employees. Work largely done using independently obtained supplies or tools supports an independent contractor finding.

INVESTMENTS IN FACILITIES

Independent contractors typically invest in and maintain their own work facilities. In contrast, most employees rely on their employer to provide work facilities.

REALIZATION OF PROFITS OR LOSS

Workers who receive predetermined earnings and have little chance to realize significant profit or loss through their work generally are employees.

WORK FOR MULTIPLE COMPANIES

People who simultaneously provide services for several unrelated companies are likely to qualify as independent contractors.

AVAILABILITY TO THE PUBLIC

If a worker regularly makes services available to the general public, this supports an independent contractor determination.

CONTROL OVER DISCHARGE

A company's unilateral right to discharge a worker suggests an employment relationship. In contrast, a company's ability to terminate independent contractor relationships generally depends on contract terms.

RIGHT TO TERMINATION

Most employees unilaterally can terminate their work for a company without liability. Independent contractors cannot terminate services without liability, except as allowed under their contracts.

Independent cntractor VS Employee