In an earlier post about IRS wage reporting requirements, we talked about the different requirements for your business’ employees and/or independent contractors. In that post, we promised that we’d explore the differences between the two classifications. Today, we’re making good on our word.
Your business may hire both employees and independent contractors. You pay both classifications of workers and, in turn, both classifications provide you with labor. So, who cares what you call them? Well, your Uncle Sam cares. For your employees, you almost always have to withhold income, Social Security and Medicare taxes, not to mention paying unemployment benefits. For independent contractors, you don’t have to withhold any of those taxes.
So, why not just call everyone an independent contractor and forget about all the payroll headaches associated with withholding? There are, of course, serious penalties for incorrect classifications. If you classify a worker as an independent contractor and the IRS determines that the worker should have been classified as an employee, you will have to pay the government all of the taxes you should have withheld and, as a kicker, you have no right to recover those costs from the worker – effectively meaning you would have paid that worker’s taxes twice. And that’s just if you make a mistake – if the IRS determines that you intentionally misclassified the worker, you will owe the government double what you should have paid (and you still can’t collect anything back from the worker, meaning you will have paid that worker’s tax liability three times).
Now that you know you don’t want to classify a worker incorrectly, either innocently or on purpose, how are you tell the difference? Sadly, this is the hard part. In 2001, the Rhode Island Supreme Court said: “the test as to whether a person is an independent contractor is based on the employer’s right or power to exercise control over the method and means of performing the work.” If that sounds fuzzy to you, that’s because it is. There is no hard and fast rule, except that your preferred label does not matter – just because you and a worker sign an independent contractor agreement does not make that worker an independent contractor.
What matters is how the relationship works in practice. The IRS published an article with some helpful guidelines. Three aspects of the employer’s “control” are examined:
- Behavioral control: Does the employer instruct the worker to perform the work in a particular place or at a particular time? Does the employer dictate the sequence of work? Does the employer evaluate the worker based on the work process or just the result? Does the employer provide training?
- Financial control: Does the employer or the worker pay for the worker’s business expenses? Is the worker free to market services to other potential employers?
- Relationship control: Is the worker expected to perform a discrete task or to perform tasks as needed? Is the worker expected to work for a specific period of time, or is the hiring open-ended? Is the worker entitled to receive benefits from the employer?
This is not an exhaustive list of factors, and no one factor is determinative of the outcome. To classify workers correctly, it’s important for businesses to assess the entire working relationship in light of the concept of control. The more control the employer exerts over the worker, the more likely it is that the worker will be considered an employee, subject to withholding.
To the extent you’re still not sure (and who could blame you), you can file IRS Form SS-8 to seek a binding determination from the government, or seek the advice of an attorney.