5 MIN READ
Employer misclassification of their employees as independent contractors is a widespread problem in the United States. The IRS estimates that employers have misclassified millions of workers nationally as independent contractors, some in error and some intentionally.
If you haven’t spent hours thinking about the independent contractor versus employee distinction, you aren’t alone. Regardless, properly categorizing your team is critical because:
- The law (not you) dictates who is an independent contractor and who is an employee.
- Employees and independent contractors are treated differently for tax purposes.
The determination of a worker as an employee or an independent contractor has significant tax implications for the worker, the employer, and the IRS because employers and workers have different tax obligations depending on employee/contractor status. Worker classification dictates who is responsible for paying Social Security tax, Medicare tax, and Federal unemployment taxes, and whether or not Federal income tax withholding is needed. Ultimately, your team’s employment classification is based on the nature of the work they do and how they do it, and you are expected to pay certain taxes based on this classification.
Unfortunately determining whether a worker is an employee or a contractor isn’t black or white, and those shades of grey open the door for error. That’s why we’ve laid out some guidelines for correctly classifying a worker as an employee or a contractor to help ensure you’ve made the right distinction.
Common Law Rules
Worker classification isn’t as simple as how an employer views (or wants to compensate) a worker. There are actual laws at play, and there are many factors to consider when classifying a worker as an employee or an independent contractor.
Hiring independent contractors can save money by reducing costs like pensions, group health insurance and worker’s compensation insurance. But while you may be tempted to classify workers as independent contractors to pinch pennies, improperly doing so will likely cost you more in the long run.
An incorrect determination could result in:
- Payment and penalties related to Social Security and Medicare taxes
- Payment of possible overtime, including penalties for a contractor reclassified as an employee
- A legal obligation to pay for benefits
As you grow your business, understanding the distinction between an employee and an independent contractor becomes even more critical.
In general, a worker is an employee if:
- Your business controls what work will be done and how it will be done (even if you give the worker freedom of action). You retain the right to control the details of how the services are performed.
- Your business provides the equipment and materials the worker uses to complete the work.
- Your business provides benefits to the worker (like paid time off, insurance, and retirement benefits).
- Your business pays the business expenses of the worker (like office rent, insurance, supplies, or other expenses and reimbursements).
In general, a worker is an independent contractor if:
- The worker services many different customers or clients who pay them directly for their services.
- The worker controls when and how the work will be performed and controls all the details of the work performed.
Seems simple, right? But that’s just a general overview of some basic differences between the two classifications. In reality, classifying workers can be a challenging task as there is no litmus test for identifying a worker as an employee or an independent contractor. There are standards though, and the IRS has laid out a detailed set of factors to help employers make correct determinations.
Like a lot of other regulations handed down from the IRS, the “right” answer isn’t always clear. The general gist? A worker’s classification is based chiefly on whether or not an employer has the right to direct or control the worker’s work. Of course there are many ways an employer can exercise control over a worker, and there is no clear definition of just how much control is enough to classify a worker as an employee rather than an independent contractor.
The general rule, as per the IRS, is that a worker “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 or how it will be done.” With that in mind, employers should examine the degree of control and independence in their relationships with their workers. So, what exactly constitutes “control?”
In the past, the IRS worked through a list of 20 different factors designed to evaluate who controls how the work is performed and thereby determine whether a worker is an independent contractor or an employee. This is termed the “Right-to-Control Test.” These factors have since been condensed into three general categories: behavioral control, financial control, and relationship of the parties.
Behavioral control regards how a worker performs the work (e.g. instructions, training). Does the firm control or have the right to control what the worker does and how the worker does his or her job? An employee is typically subject to an employer’s instructions about when, where, and how to work. The employer does not have to actually control the way the work is done, but they must have the right to. When working with independent contractors, on the other hand, the employer only maintains control over the result of the work, forfeiting control over how the work is carried out.
Financial control regards the business aspects of the worker’s activities (e.g. unreimbursed expenses, profit or loss opportunity, payment method, services available to the relevant market). Are the business aspects of the worker’s job controlled by the firm? “Business aspects” include such details as how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies. Here again it’s about the employer’s right to control the economic aspects of the worker’s job.
Type of Relationship
Type of relationship regards how the business and worker perceive their relationship (e.g. employee benefits, written contracts/intent of parties, discharge/determination). Are there written contracts or employee benefits (e.g. pension plan, insurance, vacation pay). Will the relationship continue? Is the work performed a key aspect of the business?
When classifying a worker as an employee or an independent contractor, businesses must weigh all of these factors. Some factors may indicate that the worker is an employee while others may indicate the opposite; there is no “magic number” of factors that determines status, and no one factor “makes” a worker an employee or an independent contractor. The individual circumstances of each case determine the weight the IRS assigns different factors. The IRS recommends “look[ing] at the entire relationship, consider[ing] the degree or extent of the right to direct and control, and document[ing] each of the factors used in coming up with the determination.”
Additionally, some states may have their own requirements for classifying an employee versus an independent contractor, further muddying the already murky waters.
What If You Get It Wrong?
As we’ve seen, the determination of a worker as an employee or an independent contractor is not clear-cut. This vagueness leads many businesses to mistakenly believe that they have some wiggle room in determining how to classify their workers—they don’t, and misclassifying workers can be costly. If you pay a worker who should be an employee as an independent contractor with no basis for doing so, you may be held liable for employment back taxes for that worker and interest and penalties to boot.
Employers who are uncertain of 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. This process can take up to six months to complete and results in an official determination of a worker’s status by the IRS.
Knowing how to classify workers is an essential skill for every business owner. Get it right and you’ll know you’ve hired the right type of worker for your business, and you can rest easy knowing that your business complies with IRS requirements.