Tax Blog

The Do’s and Don’ts of Classifying Workers as Employees vs. Independent Contractors

Why should you care about the do’s and don’ts of classifying workers as employees vs. independent contractors?

One simple answer, and it has to do with avoiding financial penalties and criminal court: tax fraud.

On wages paid to an employee, you are responsible for withholding income taxes. In addition, you must withhold and pay Social Security tax, Medicare tax, and pay (although not necessarily withhold) unemployment tax on wages paid to an employee. In contrast, you do not have to withhold or pay any taxes on payments to independent contractors.

Misclassifying employees as independent contractors is one form of tax fraud, which is prosecuted severely by the IRS.

Generally speaking, employers are responsible for managing employees’ income, Social Security, Medicare, and unemployment taxes. Employers are not responsible for any of these taxes for wages paid to independent contractors.

So why would any company hire employees instead of classifying all their workers as independent contractors?

You might get an earful if you ask an Uber executive about this. You may remember Uber in the news for classifying their drivers as independent contractors instead of employees? The original ride-sharing business model seemed to be based on the inherent tax advantages that would be available to a large company whose workforce was almost entirely made of independent contractors. The courts eventually ruled against Uber and other ride-sharing companies, requiring them to reclassify their drivers as employees.

The advantages of hiring an independent contractor instead of an employee include:

  • Freedom from tax requirements
  • Freedom from regulations involving overtime and benefits,
  • The temporary nature of the relationship, which is especially useful for small businesses
  • Independent contractors often bring their own tools and are expected to need little training or oversight.

The advantages of hiring an employee include:

  • Full control of the employee’s work during work time. Independent contractors are only under contract to perform a specific, pre-determined job.
  • You can train the employee to do your job the way you want it done.
  • You can require that an employee works only for you. Independent contractors are independent and may accept other gigs, even from your competitors.
  • You can terminate the employee with relatively few restrictions. Independent contractors, on the other hand, could legally expect to have their contract paid in full, even if you change your mind about requiring their services.

When dealing with an independent contractor, the payer has the right to control or direct only the result of the work, not what will be done and how it will be done.

It may seem straightforward enough, but as the drawn-out, headline-grabbing Uber court cases indicate, there is enough gray area to keep tax attorneys hopping. The IRS recently used a 20-factor test to help employers differentiate between an employee and an independent contractor.

Although this 20-factor test is no longer officially recommended by the IRS, it is a quick way to get a broad idea of how the IRS makes the distinction between independent contractors and employees.

1. Compliance with instructions. Employees must comply with another person’s instructions on when, where, and how the work is performed. In a true
independent contractor relationship, the only control to which the contractor is subject is the result.
2. Training required. Independent contractors are not normally trained but rather are hired for their expertise in a field.
3. Integration of services into business operations. Employees’ services are usually a vital part of the daily operation of an employer’s operation.
4. Services rendered personally. Employees personally render the services, while contractors may delegate such work to others.
5. Hiring, supervising, and paying assistants. Usually individuals who perform all these functions are treated as independent contractors.
6. Continuing relationship. Employees are usually hired for an ongoing period, while a contractor’s work ends when the job ends.
7. Set hours of work. Employees usually must adhere to a work schedule established by the employer.
8. Full-time required. Generally, employees work full-time for an employer, while independent contractors work when and for whom they choose.
9. Performing work on the employer’s premise. Those working at the employer’s site may be viewed as employees.
10. Services performed in order or sequence set. Persons told to perform work in a certain sequence generally are considered employees.
11. Oral or written reports. Employees are more likely to be required to submit regular reports to the employer.
12. Payment by hour, week, month. Typically, employees are paid on a regular basis, while independent contractors are compensated by the job or on a
lump-sum or straight commission basis.
13. Payment of business and/or travel expenses. Employer payments of a person’s work-related travel expenses generally indicates employee status.
14. Furnishing of tools and materials. Employees, not individual contractors, are generally provided with supplies.
15. Significant investment. Individuals who have a significant personal investment in the facilities they use for work are normally independent contractors.
16. Realization of profit or loss. Unlike employees, independent contractors realize a profit or loss based on their success in performing a service.
17. Working for more than one firm at a time. Individuals who perform services for a number of employers are usually independent contractors.
18. Making services available to general public. Individuals who regularly make their services available to the general public are usually treated as
independent contractors.
19. Right to discharge. Employees can be fired, while independent contractors cannot be discharged if they fulfill contract specifications.
20. Right to terminate relationship without incurring liability. An employee can terminate his employment relationship with his employer at any time,
whereas an independent contractor may be liable for breach of contract for leaving work unfinished.

The IRS now uses only three criteria, instead of twenty, to determine whether a worker should be classified as an employee or an independent contractor. These criteria are behavioral control, financial control, and type of relationship.

  1. Behavioral control means that you can determine how your employees spend their time, control the work environment (within safety regulations), set their hours, and determine the tools they use. You train your employees and dictate how the work should be completed. Independent contractors set their own hours and use their own tools and training.
  2. Financial control means that you pay your employee a salary or a regular wage. Independent contractors are usually paid a flat fee per job or gig.
  3. Type of relationship means that employees perform jobs that are related to your business’ day-to-day core work, you grant them benefits such as sick days and health insurance, and you expect that they will work for you indefinitely. Independent contractors fill temporary needs within the company.

If you’ve misclassified employees in the past, or have had any run-ins with the IRS due to misfilings or accumulated tax debt, don’t hesitate to call our tax resolution specialists. They can help you find relief from tax penalties from previous years and structure your business to minimize your tax burden.