(This post is part of my Small Business Startup & Survival Guide. You can catch up on the whole series here.)
When you’re a small business, you might not have the resources (nor the need) for a full time staff. You might opt to have one or two employees who work part-time, one or two who work full time and depending on your circumstances, you might fill in the gaps on a seasonal basis by hiring temporary employees. If you do that, which of your workers are considered to be employees and which are considered to be independent contractors? The answer is, “It depends.” All of them could potentially be your employees.
One of the big mistakes that employers often make is assuming that only full-time permanent workers are employees. This is not true. Employees can be full time or part time, seasonal or year round, temporary or permanent. The question of how to characterize workers as employees versus independent contractors may be dependent on a lot of factors but the length of employment is not one of them.
So what distinguishes an employee from an independent contractor? Here’s what the Internal Revenue Service (IRS) says:
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 and not what will be done and how it will be done.
Or, to put it simply, it’s a question of control.
The more likely you are to control the terms of the employment, the more likely you are an employer. If, as the employer, you control how the worker performs his or her job, chances are that the worker is an employee.
Obviously, control is relevant and cases are fact specific. To help you out, Internal Revenue Service (IRS) developed a list of 20 factors to be considered outlined in Revenue Ruling 87-41. They are:
- Instructions. Is the worker required to comply with another person’s instructions about when, where, and how he or she is to work?
- Training. Is the worker trained by the employer?
- Integration. Is the worker is an integral part of the employer’s business?
- Services rendered personally. Is the worker required by the employer to render the services personally?
- Hiring, supervising and paying assistants. Is the hiring, supervising and paying of assistants for the worker done by the employer?
- Continuing relationship. Is there a continuing relationship between the worker and the employer?
- Set hours of work. Does the worker have work hours set by the employer?
- Full time required. Does the worker normally work full time for the employer?
- Work done on premises. Is the work performed on the premises of the employer?
- Order or sequence set. Is the order of the work performed by the worker set by the employer?
- Oral or written reports. Is the worker required to submit regular or written reports to the employer?
- Payments by hour, week or month. Is the worker paid by the hour, week or month?
- Payment of expenses. Does the employer ordinarily pay the worker’s business and/or travel expenses?
- Furnishing of tools and materials. Does the employer furnish the worker’s tools, materials and other equipment?
- Significant investment. Has the worker significantly invested in the facilities where the worker performs services?
- Profit or loss. Does the employer pay for the worker’s time, no matter the outcome, protecting the worker from losses or limiting the right to a profit?
- Working for more than one firm at a time. Is the worker only performing services for one employer?
- Making services available to the general public. Does the worker limit services to the employer as opposed to making his or her services available to the general public on a regular and consistent basis?
- Right to discharge. Can the employer discharge the worker?
- Right to terminate. Can the worker quit at any time without incurring liability?
The more that the answer is yes to these questions, the more likely it is that the worker is an employee and not an independent contractor. Of course, that list isn’t written in stone (just in a Revenue Ruling!). The criteria is subjective and there’s no magic number of times you can answer yes that conclusively determines the outcome.
Since those factors are helpful but not determinative, IRS has updated its checklist to three categories of factors to be used in conjunction with the 20 questions. They are:
- Behavioral Control. Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial Control. Are the business aspects of the worker’s job controlled by the payer?
- Type of Relationship. Are there written contracts or employee type benefits? Will the relationship continue and is the work performed a key aspect of the business?
As an employer, you must must weigh all these factors to determine whether a worker is an employee or independent contractor.
So why do you care? Isn’t this just about a paycheck? Not at all. Employers have different obligations towards employees than they do towards independent contractors.
An employer-employee relationship is governed by state and federal laws. As the employer, you may be required, in addition to withholding and remitting payroll taxes, to provide health care for employees. Depending on the level of perks offered at the company, an employer may have to extend retirement packages, stock option plans, gym memberships and other benefits to employees.
In contrast, an independent contractor is responsible for paying Self-Employment Tax (SE) in addition to income tax. An employer does not withhold any payroll taxes, including Social Security and Medicare taxes, or pay the employer portion of those taxes for an independent contractor. An employer is not responsible for providing paid benefits and tax-favored opportunities like health care insurance and retirement plans for an independent contractor. An employer is not required to offer stock options or other incentive plans to an independent contractor. And when an independent contractor leaves – for whatever reason – there is generally no severance or unemployment compensation payable. In short, an independent contractor is, well, independent.
Sounds great for a small business, right?
Maybe. From a financial perspective, it can be easier to pay an independent contractor. It’s a flat check. No withholding. No perks. No benefits. No extra forms to file. And at the end of the tax year, you won’t provide an independent contractor with a form W-2. Rather, you’ll provide an independent contractor with a form 1099-MISC that typically just includes total wages paid.
From a business perspective, however, it might not be as desirable. There is something to be said for loyalty. Employees may remain loyal, while independent contractors often make it clear that that they will go where the next job may be. That can make continuity in a business difficult.
So who makes the decision about whether a worker might be an employer or an independent contractor? You, as the employer, do. Not because you might say so but rather because of how you act. No matter how you choose to classify your worker, no matter what any written contract might say, how you act – those factors listed above – means everything.
What happens if you do it wrong? If you erroneously classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker. Depending on circumstances, you may be required to retroactively apply benefits. In some instances, you can also face legal action.
If you’re reading this and in a bit of a panic because you’ve been getting it wrong, there is help available. The IRS offers a Voluntary Classification Settlement Program (VCSP) that allows employers to reclassify workers as employees for future tax periods and obtain some tax relief. To participate, a business owner must meet certain eligibility requirements. For more information, check out the VCSP page on the IRS website or check with your tax professional.