When you hire someone to work for your business, you will need to make a distinction each time: Is this individual an employee or an independent contractor?
This is a crucial distinction and the factors and circumstances surrounding your work relationship should be closely evaluated when making the determination. There is no specific number of factors that must weigh in favor of independent contractor or employee status in order to classify the worker as such and there is no single factor that can make the determination alone.
How to Make the Distinction
To determine your classification for federal tax purposes, one must look to common law. The IRS issued a Fact Sheet on July 20, 2017 which identifies the many factors that the IRS considers in determining whether a worker is an independent contractor or an employee for federal tax purposes. These factors fall into three categories:
- Behavioral control
- Financial Control
- Relationship of the Parties
1. Behavioral Control
A worker is an employee when the employer has the right to control and direct the work of the worker. It does not matter if the employer actually does control or direct the work as long as the employer has the right to do so.
A court will evaluate:
(a) Type of instructions
(b) Degree of instruction
(c) Evaluation systems
(d) Training
a. Type of Instructions
A worker who is subject to the company’s instructions about how to work, when to work, where to work, what tools to use while working, and the sequence to follow when performing the work, is likely an employee.
b. Degree of Instruction
Similarly, if the worker is subject to detailed instructions from the company, that would indicate an employee-relationship because the business is controlling the work done by the worker. Alternatively, less detailed instructions indicate less control and suggest an independent contractor relationship.
c. Evaluation Systems
If an evaluation system is used to measure how the work is performed this suggests an employee relationship. On the other hand, if an evaluation system is used to measure the end result, this suggests an independent contractor relationship.
d. Training
If the company trains a worker how to do the job, the worker will likely be classified as an employee. Conversely, independent contractors typically perform a job using their own methods.
2. Financial Control
If the business has a right to direct or control the financial and business aspects of a worker’s job, the worker is likely an employee. The court considers the following factors:
(a) Significant Investment
(b) Unreimbursed Expenses
(c) Opportunity for Profit or Loss
(d) Services Available to the Market
(e) Method of Payment
a. Significant Investment
Independent contractors typically spend a great amount of money on the equipment they use to perform their services. It is not necessary, however, to have a significant investment in equipment in order to be classified as an independent contractor.
b. Unreimbursed Expenses
While is possible that employees incur unreimbursed expenses, it is more likely that independent contractors do so. This factor, if applicable, weighs in favor of independent contractor status.
c. Opportunity for Profit and Loss
The possibility of incurring a loss on the sale of their services is an indication that the worker is an independent contractor. Employees are typically paid wages and do not incur a loss for their services. Similarly, the opportunity to realize a profit is typically associated with independent contractor status.
d. Services Available to the Market
Independent contractors typically seek out various business opportunities in the market. Whereas, an employee usually works for the business on a continuous and indefinite basis.
e. Method of Payment
Independent contractors are often paid a flat fee on a per-job basis. Employees are typically paid a regular wage amount based on an hourly or yearly rate.
3. Relationship of the Parties
Whether a worker is an independent contractor or employee may depend on how they perceive their relationship with the business they perform services for. The factors the court considers are:
(a) Written Contract
(b) Employee Benefits
(c) Permanency of the Relationship
(d) Services Provided as Key Activity of the Business
a. Written Contract
A written contract that describes the parties’ intention can be helpful but is not sufficient to determine the worker’s classification. Instead, it is the parties relationship and evaluation of the factors described herein that determines the classification of the worker.
b. Employee Benefits
Businesses usually do not provide benefits, including insurance, pension plans, paid vacation and sick leave to independent contractors. A grant of these benefits to a worker is an indicator of an employee relationship but a lack of these benefits does not mean the worker is an independent contractor.
c. Permanency of the Relationship
Hiring a worker for a specific project or for a specific period of time, suggests independent contractor status. Hiring a worker for an indefinite duration suggests employee status.
d. Services Provided as Key Activity of the Business
If the worker is providing services at the core of what the business does, it is likely that the business is also controlling the worker’s services. This suggests an employee relationship. If the services performed are not seen as a key aspect of the regular business of the company, the worker is more likely to be an independent contractor.
Consequences of Misclassifying
If your worker is classified as an employee, you will need to withhold, deposit, report and pay employment taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid. If your worker is an independent contractor, he or she will pay their own income tax.
Tread lightly. If you misclassify an employee as an independent contractor, your business may be liable for unpaid employment taxes down the road.
If you need help determining whether a worker is an independent contractor or an employee, or if you need help determining whether you were correctly classified, Goodell DeVries can help. Contact Kaitlin Corey at 410-783-3526 (kcorey@gdldlaw.com).
