Print Posted by National Association of Tax Professionals on 09/24/2014

Employee or Independent Contractor? - Determining the proper worker status

Employee or Independent Contractor? - Determining the proper worker status

When you hire someone to work in your business, that individual will either be an employee or independent contractor for tax purposes. Failure to properly classify the worker can subject you to an IRS audit and possibly interest and penalties for failing to withhold and deposit payroll taxes. Under common-law rules, if you have control over what work is being done and how it will be done, you are generally regarded as an employer and the worker is considered your employee.

The IRS uses three factors to determine the proper worker classification. Behavioral control refers to facts that show whether there is a right to direct or control how the worker does the work. Behavioral control looks at the type of instruction given, the degree of instruction, an evaluation system, and training.

The second factor is financial control. Financial control refers to facts that show whether or not the business has the right to control the economic aspects of the worker’s job. Financial control factors consist of significant investment, unreimbursed expenses, opportunity for profit or loss, services available to the market, and method of payment. If you provide the tools and supplies to do the job, set the work hours, provide the location where the work is performed, and can hire or fire the worker, chances are this worker is classified as an employee. However, if the worker provides his own tools and supplies, performs services for an agreed price, performs these same services to others, and maintains control over how the work is completed, the worker is more likely an independent contractor.

The third factor is the type of relationship between you and the worker. Under type of relationship, take into consideration any written contracts, employee benefits, permanency of the relationship, and services provided as the key activity of the business. An employee will be hired for a long-term relationship and employee benefits will generally be provided.

You must weigh all of these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate an independent contractor. The key is to look at the entire relationship you have with the worker, consider the degree or extent of the right to direct or control, and finally document each of the factors used in arriving at a determination.

If you are unsure whether your newly hired worker is an employee or independent contractor, you may file Form SS-8 with the IRS. They will assist you in making a proper determination, thus avoiding mistakes, audits, and additional taxes and penalties.

For some business owners, determining whether a worker is an employee or an independent contractor can be tricky. Generally, you must withhold income taxes, withhold and pay social security and Medicare taxes and pay unemployment tax on wages paid to an employee. However, you don’t generally have to withhold or pay any taxes on payments made to independent contractors.

There is a misconception that you may be able to choose which classification works best for your company. In reality, however, the facts and circumstances impose the worker status. In determining whether the person providing a service is an employee or an independent contractor, you must consider all information that provides evidence of the degree of control and independence.

You’ll need to answer these four questions:

1. Does the company control or have the right to control what the worker does and how the worker does his or her job?

2. Are the business aspects of the worker’s job controlled by the payer? Examples include how a worker is paid, whether expenses are reimbursed and who provides tools/supplies.

3. Are there written contracts or employee-type benefits like a pension plan, insurance, vacation pay? 

4. Will the relationship continue and is the work performed a key aspect of the business? 

Businesses must weigh all these factors when determining whether a worker is an employee or   independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. No set number of factors makes the worker an employee or an independent contractor and no single factor stands alone in making this determination. 

The concept is to look at the entire business relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.

If you 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. File a Form SS-8 with the IRS if the factors for determining worker status remain unclear.

Contact This Member