Employee or Independent Contractor – And Why it Matters

Misclassifying labor can have costly consequences

Employee vs. Independent Contractor

A common issue many businesses face is whether workers should be classified as an employee or contractor. Many workers who are treated as independent contractors are actually employees and this misclassification can have costly consequences.

What is an Employee?

An employee is under the control of their employer. The employer determines the details of what the employee will do and how the work will be completed. An employer must withhold federal income taxes, social security and Medicare taxes, and pay unemployment tax on wages paid to an employer. Employees may be entitled to certain benefits, protections, and rights that independent contractors are not, such as health insurance, paid leave, workers compensation and unemployment insurance.

What is an Independent Contractor?

An independent contractor operates as an independent business and may perform work for multiple clients. Typically, an independent contractor provides their own tools and equipment. An employer does not have to withhold and pay tax on payments made to an independent contractor.

Misclassification Risks

If the IRS were to reclassify an independent contractor as an employee, the employer is liable for employee taxes that should have been withheld, in addition to the employer’s share of FICA taxes. The employer would also likely be charged with penalties and interest for failure to pay these taxes and file payroll tax returns. The penalties and interest can quickly become significant. In addition to the tax issues, an employer who excluded eligible participants by incorrectly treating them as independent contractors may have a retirement plan disqualified, which could cause all vested benefits to become taxable for all plan participants.

IRS Factors for Classifying Workers

To determine whether a worker is classified as an employee or independent contractor, the IRS uses a set of 20 factors, referred to as the common law rules.

1. Instructions. If the company directs when, where, and how work is done, this control indicates an employer-employee relationship. 
2. Training. Requesting or requiring workers to undergo company-provided training suggests an employment relationship since the company is directing the methods by which a worker performs their duties. 
3. Integration. Workers whose services are central to the business operations or significantly affect business outcomes are likely to be considered employees. 
4. Services. Companies that insist or demand that a particular person performs the work have asserted a high degree of control, which indicates an employment relationship. In contrast, independent contractors are typically free to assign work to anyone. 
5. Hiring, supervising, and paying. If a company hires, supervises, and pays a worker’s assistants, this control suggests an employment relationship. If the worker gets to control the hiring, supervising, and paying of assistants, they could be defined as an independent contractor. 
6. Continuing relationship. A continuous relationship between a company and a worker indicates an employment relationship. However, an independent contractor arrangement can also be an ongoing relationship that spans multiple projects. 
7. Flexibility of schedule. If a company gets to dictate a worker’s days and hours of work, this degree of control suggests an employer-employee relationship. 
8. Full-time requirement. Workers who work full-time hours suggests a company has control over most of their time, which indicates an employment relationship. 
9. Employer’s premises. Requiring someone to work on company premises if the work could be performed elsewhere — suggest an employer-employee relationship. 
10. Order of sequence. If a company requires work to be performed in specific order or sequence, this type of control suggests an employment relationship. 
11. Oral or written reports. If a worker is required to regularly provide written or oral reports on project status, they could be viewed as an employee. 
12. Timing of payment. If a worker is paid hourly, weekly, or monthly, this could suggest an employment relationship, unless the payments simply are a convenient way of distributing a lump-sum fee. An independent contractor is more likely to be paid by the job.
13. Business and/or travel expenses. An employee is more likely to have expenses paid by the person for whom services are performed.
14. Tools and materials. Workers who use company-provided equipment, tools, and materials to perform their work are more likely to be considered employees. Work largely done using independently obtained supplies or tools supports an independent contractor classification. 
15. Significant investment. While independent contractors usually pay for their own work facilities, most employees rely on their employer to provide work facilities. 
16. Realization of profit or loss. If a worker’s earnings are predetermined and have little chance to realize significant profit or loss through their work, they are generally considered to be an employee. 
17. Working for more than one firm. Independent contractors are more likely to perform services for multiple companies.
18. Services available to the public. If a worker regularly makes services available to the general public, they could qualify as an independent contractor. 
19. Right to discharge. If a company has right to discharge a worker, this suggests an employment relationship.
20. Right to terminate. Most employees can terminate their work for a company without liability.

Determining Employee or Contractor Status

The importance of each factor depends on the facts and circumstances of every case and there is not one single factor that determines the classification but rather a combination of factors. The IRS generally focuses on behavioral control, financial control, and the nature of the relationship. If in doubt and unable to decide, you may file Form SS-8 with the IRS, and they will make the determination for you.

Employers should regularly review worker classification to ensure compliance. If you have questions or need assistance, contact our tax team.