Differences Between an Independent Contractor and Employee: Key Issues
The distinction between employees and independent contractors is vital for employers. The status of someone who works in your business makes a difference in how you pay them and in how they pay taxes. The Internal Revenue Service (“IRS”) encourages all businesses and business owners to understand the rules when it comes to classifying a worker as an employee or an independent contractor. For federal employment tax purposes, a business must examine the relationship between it and the worker. The IRS Small Business and Self-Employed Tax Center offers helpful resources.
Worker classification is important because it determines if an employer must withhold income taxes and pay Social Security, Medicare taxes and unemployment tax on wages paid to an employee. Businesses normally do not have to withhold or pay any taxes on payments to independent contractors. The earnings of a person working as an independent contractor are subject to self-employment tax.
The general rule is that an individual is an independent contractor if the payer/employer has the right to control or direct only the result of the work, not what will be done and how it will be done. Small businesses should consider all evidence of the degree of control and independence in the employer/worker relationship. Whether a worker is an independent contractor or employee depends on the facts in each situation.
Here are key points for business owners to keep in mind when it comes to classifying workers:
i. Behavioral Control
Behavioral Control refers to facts that show whether there is a right to direct or control how the worker does the work. A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised.
Behavioral control categories are:
Types of instruction given: An employee is generally subject to the business’s instructions about when, where, and how to work, what tools or equipment to use, what workers to hire or to assist with the work, where to purchase supplies and services, what work must be performed by a specified individual, what order or sequence to follow when performing the work.
Degree of instruction, more detailed instructions may indicate that the worker is an employee. Less detailed instructions reflect less control, indicating that the worker is more likely an independent contractor.
Note: The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker's performance or instead has given up that right.
Evaluation systems to measure the details of how the work is done points to an employee. Evaluation systems measuring just the end result point to either an independent contractor or an employee.
Training a worker on how to do the job -- or periodic or on-going training about procedures and methods -- is strong evidence that the worker is an employee.
ii. Financial Control
Financial Control: Does the business have a right to direct or control the financial and business aspects of the worker's job? Consider:
Significant investment in the equipment the worker uses in working for someone else.
Unreimbursed expenses: independent contractors are more likely to incur unreimbursed expenses than employees.
Opportunity for profit or loss is often an indicator of an independent contractor.
Services available to the market: independent contractors are generally free to seek out other business opportunities.
Method of payment: an employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time even when supplemented by a commission. However, independent contractors are most often paid for the job by a flat fee.
Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. This includes:
Written contracts which describe the relationship the parties intend to create. Note: a contract stating the worker is an employee or an independent contractor is not sufficient to determine the worker’s status.
Benefits: businesses providing employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay suggest an employment relationship. Businesses generally do not grant these benefits to independent contractors.
The permanency of the relationship is important. An expectation that the relationship will continue indefinitely, rather than for a specific project or period, is generally seen as evidence that the intent was to create an employer-employee relationship.
Services provided which are a key activity of the business. The extent to which services performed by the worker are seen as a key aspect of the regular business of the company.
Employers can utilize Form SS-8 published by the IRS to assist in determining the status of their workers by using the form. If the situation is nebulous, employers should contact a small business attorney to help in its determination. IRS Publication 15-A, Employer's Supplemental Tax Guide, is also an excellent resource.
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