Employee or Contractor?

By Rick Roddis

Seems like a simple enough question. But the rules surrounding whether a worker is an employee or independent contractor are complex. And misclassification can lead to significant legal and financial troubles.

Take the IRS, for example. It has a vested interest in how you classify. One of the goals of the agency is to maximize tax revenue. So the IRS wants to ensure you’re properly withholding and submitting employee taxes. If you’re not, you could owe back taxes, back wages and be at risk for employee lawsuits.

How Does the IRS Define a Contractor?

The IRS uses the “Right to Control” test, sometimes called the “Common Law” test. It looks at several factors across three categories.

  1. How you behave toward the worker.
  2. The financial arrangement you have with the worker.
  3. The nature of the relationship with the worker.

How You Behave Toward the Worker

In the behavior category, the main question is whether you are acting like the worker’s employer. If you’re working with contractors, you’re not their boss. You should not set work hours, assign a workspace or provide equipment. Independent contractors should be treated like vendors.

You shouldn’t have to provide training to the worker. Contractors should already have the essential skills to do the job.

And finally, the behavior category looks at how you monitor performance. You shouldn’t be conducting performance reviews, for example, for your contractors.

Your Financial Arrangement With the Worker

The financial category looks at who pays for what, among other factors. Independent contractors should pay for their own business expenses, provide their own equipment and be paid by the project (not hourly or salaried).

The opportunity to make a profit or loss is also important. If a worker has a significant investment in the equipment used – and if the worker has unreimbursed expenses – the worker has a greater opportunity to lose money (i.e., their expenses will exceed their income from the work). Having the possibility of incurring a loss is an indication that the worker is an independent contractor.

Additionally, the worker should have other customers and be free to pursue other projects.  Independent contractors often advertise, maintain a visible business location, and are available to take on additional work.

Your Relationship With the Worker

Here, the IRS explores the relationship between you and the worker. For example, is there a written contract that says the worker is an independent contractor? This can go a long way to show intent on both your parts. Or are you providing benefits, such as paid time off? That could indicate an employee relationship.

Another factor is permanency of the relationship. If you hire a worker with the expectation that the relationship will continue indefinitely – rather than for a specified time period – that could be evidence that the intent was to create an employer-employee relationship.

Finally, contractors should not provide your core business services. Why? If a worker provides services that are a key aspect of the business, the business can direct and control the worker’s activities. For example, if a law firm hires an attorney, it’s likely the company will present the attorney’s work as its own and would have the right to manage the work. And that could be a sign that the worker is an employee under the law.

Weighing All the Factors

Businesses must consider all of these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate the worker is an employee, while others demonstrate the worker is an independent contractor.

There’s no “magic formula” that makes the worker an employee or an independent contractor. Determining status is subjective. You want to make sure there aren’t too many indicators the worker should be classified as an employee.

The keys are to look at the entire relationship, consider the extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.

When Classification is Still in Question

If, after reviewing the evidence, you’re still not sure how to classify a worker, you can file IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. This IRS will review the facts and officially determine the worker’s status. But when in doubt … it’s always best to err on the side of caution and treat the worker as an employee.

Rick Roddis is President of ComplyRight Tax Services, a division of ComplyRight, Inc., a provider of cutting-edge compliance products and programs for businesses. Over the past four years, he’s focused on transforming ComplyRight Tax Services from a traditional forms manufacturer to a digital provider of tax solutions for businesses through services like eFile4Biz.com.

Employee stock photo by mary416/Shutterstock