A business might pay an employee and an independent contractor for providing similar or even the same work, but there are important legal differences between the two. Determining whether a worker is an employee or a contractor is not always a cut and dry decision, but rather requires an analysis of multiple factors. Unfortunately, there is no bright-line test, and for each situation the individual facts and circumstances involved must be analyzed. In the past, the Internal Revenue Service (IRS) has a list referred to as the “20-Factor Test”, but some of the factors are no longer as relevant as they once were. Now this list, which can be found on the IRS website, is used as more of an analytical tool and more emphasis is put on the overall situation by IRS agents.
What Is an Employee?
An employee is someone who works in exchange for a specific wage or salary. The employer withholds income tax, Social Security, and Medicare from wages paid. The characteristics typical of an employee include:
• Typically only work for one company
• Eligible to receive benefits
• Job training provided
• Do not have to supply their own tools or workspace
What Is a Contractor?
An independent contractor typically works for themselves, oftentimes as freelancers who consult or work on specific projects. They make their money by providing services to various clients/companies. The customer does not withhold taxes from funds paid to the independent contractor. Employment and labor laws also do not apply to independent contractors. Here are some characteristics typical of an independent contractor:
• Set their own hours
• Negotiate their own rates and fees
• Choose their own workspace
• Can work for multiple companies
• Use their own tools
Making a Determination
To determine whether a worker is an employee or an independent contractor, a company must weigh certain factors to identify the degree of control it has in the relationship. Generally speaking, the more control the company has, the more likely the recipient is an employee. The more independence the worker has, the more likely they are an independent contractor. There are three main categories to focus on when making this determination: behavioral control, financial control, and relationship of the parties. Below are some examples of these factors.
1. Behavioral Control
Does the business have the right to direct and control the worker, even if the right is not being exercised:
• Employees are subject to more direct control.
o What work is being performed?
• How is the work being completed? With contractors the customer is generally more concerned with the end results than with the processes.
• The degree of instructions provided.
o More detailed instruction and supervision usually indicates an employee.
• Periodic or ongoing training on how to do the job.
o Contractors normally already have the necessary skills and training.
2. Financial Control
Does the company control the financial and business aspects of the worker’s job:
• How is the worker paid?
o Hourly or salary are most common for employees.
o Flat fee by job or a commission is common for contractors.
• Are worker’s expenses reimbursed by company?
o Contractors are more likely to incur unreimbursed expenses than an employee.
• Can a profit or loss be incurred?
o A contractor can control the costs associated with the project and earn a profit if the job is managed well, or suffer a loss if the costs exceed expectations.
o Since an employee’s expenses are reimbursed, they do not have the risk of financial loss.
• Who provides the tools and supplies?
o A significant investment is often a good indicator of a contractor.
• Does the worker work predominantly or completely for one company?
o If so, the worker is likely an employee.
3.Relationship of the Parties
• Is there a written contract?
o An employment contract spells out job title and description, if there will be a probationary period, frequency and amount of pay, and benefits, among other factors.
o A contractor agreement will indicate the duration, services to be provided by the contractor, and how much and when the contractor will be paid.
• Are there benefits provided such as insurance, PTO (sick or vacation), or a retirement plan?
• Will the working relationship continue?
o Employees are often thought of as more indefinite or “long-term.”
o Contractors are likely to be more “short-term” or have a fixed period of engagement.
• Is the work being provided a key aspect of the business and is the service being provided similar to the work the business does for its customers?
o If the worker provides the same services as the business itself, the worker is likely an employee.
o The more vital a worker is to the business, the more likely they should be classified as an employee.
o If the worker is in a different line of business or has a specialized skill, they can be classified as a contractor.
Different Factors for Different Reporting Agencies
While the IRS has their own guidelines in resolving the employee vs. contractor issue, it is important to recognize that the IRS and Department of Labor (DOL) have different standards. Each state also has different tests regarding workers’ compensation and unemployment insurance laws. Many states use an economic realities test that makes it harder to classify a worker as an independent contractor. In addition to the test regarding degree of control, many states also consider how economically dependent the worker is on the business.
Consequences of Misclassification
An employer must show that there is a reasonable basis to classify a worker as an independent contractor in order to escape the burden of paying employment taxes for the worker. If it is determined that a contractor should have been classified as an employee, the IRS may hold the company responsible for the employment taxes of the worker. If it is determined by the IRS to be “willful neglect”, substantial penalties could apply. Conversely, if a company includes an independent contractor in their defined benefit pension plan, it risks the plan losing its tax-exempt status. Misclassification can also affect unemployment compensation claims. If a contractor files for unemployment with the state, it may decide that the facts and circumstances warrant that they really should have been an employee. As a result, the business could be subject to having to pay additional fines and penalties beyond just the unemployment claim.
If a clear decision cannot be reached by the business as to how to classify a worker, it would be best to consult a tax professional or business attorney. They can help the business contact the proper governmental authority to request a ruling. If in doubt, the worker is most likely an employee and should be treated as such. It is prudent to err on the side of caution in uncertain circumstances, as a worker misclassification can bring unintended headaches to a company. If the circumstances surrounding a worker’s classification are nebulous, use the tools available for determination of status and be sure to document the conclusion for substantiation in the event of an examination of the classification.
ABOUT WITHUMSMITH+BROWN, PC (WITHUM)
Withum provides clients in the hospitality, vacation ownership and other industries with assurance, accounting, tax compliance and advisory services. For further information about Withum and the services they provide to the industry, contact Lena Combs (LCombs@withum.com) at (407) 849-1569 or visit www.withum.com.