The employee vs.
independent contractor debate
Managers often do not understand the
effect of classifying
an individual as an employee or an independent
contractor. Properly classifying a worker as an
independent contractor may save a company money and
benefits, such as pension, group health and workers'
compensation insurance, as well as social security and
unemployment insurance taxes. In most cases, the only tax
form employers have to complete is a Form 1099-MISC at
the end of the tax year for workers classified as
independent contractors. Classifying workers as
employees, on the other hand, requires that the company:
withhold federal, state, and local income taxes; pay half
of the tax mandated under the Federal Insurance
Contributions Act (for Social Security and Medicare); pay
the full tax required under the Federal Unemployment Tax
Act and any state unemployment insurance tax laws; pay
for workers' compensation; file a number of returns
during the course of the year with the various tax
authorities; and provide W-2s by January 31. The employee
may also have rights to any employee benefits, such as
health insurance, vacations, holidays, or retirement
plans.
The following material
includes information about:
 The 20-factor control
test used to classify employees
The
risks of misclassifying employees
How to play it safe
Common
myths to avoid
Safe harbors
Employee
or independent contractor?
The determination of whether a worker
is an employee or an independent contractor depends
primarily on the extent to which the person receiving the
services has the right to direct and control the service
provider with regard to what is to be done and how it is
to be done. An employer generally has the right to
control how an employee performs the service. Independent
contractors determine for themselves how the work is to
be performed.
The 20-factor control test is a set of
guidelines to be used to indicate the extent of direction
and control present in any situation. These factors have
been developed by the Internal Revenue Service and are
used in connection with IRS audits concerning worker
status. Not all factors need to be present in any given
situation, and no single factor is controlling. The
importance of each factor may vary depending on the
situation. The greater the degree of control that exists
based on these factors, the more likely it is that the
individual will be an employee.
Return to
top
The 20-factor control test
Instructions
Is the individual required to comply with
instructions about when, where, and how work is
to be performed? This suggests employee status.
Training
Individuals who are trained to perform a job in a
particular method or manner are usually
considered employees. Training can include that
provided by an experienced worker, requiring the
worker to attend meetings, or by corresponding
with the worker or other methods. An independent
contractor, on the other hand, usually uses his
or her own methods and doesn't receive training
from the purchaser of his or her services.
Integration
Are the services performed integrated into the
operations of the business? This usually shows
the individual is subject to control and
direction, thus classifying him or her as an
employee.
Personal services
If the business requires that the services be
performed in person and the employer has
substantial interest in how the results will be
achieved, this suggests control over an employee.
Use of assistants
An independent contractor hires, directs, and
pays for his or her own assistants; supplies his
or her own materials; and works under a contract
providing that the worker is responsible only to
achieve certain results. If the business hires,
pays, or supervises assistants to help the
individual performing the services under
contract, it suggest an employer-employee
relationship.
Ongoing relationship
Whether part-time, seasonal, or just irregular,
ongoing work suggests the worker is likely to be
an employee.
Fixed hours of work
Independent contractors set their own work hours
while employees' hours are determined by the
employer.
Full-time work
This suggests employee status because the
employer controls the time of work and restricts
the worker from taking other jobs.
Work location
The place where the individual performs his/her
work or services is another factor considered by
the IRS. If the worker performs services away
from the employer's premises
("off-site"), this may suggest
independent contractor status. Of course, many
properly classified independent contractors will
work on the employer's premises.
Work flow
Routines, schedules, and patterns established by
the employer for a worker indicate employee
status.
Reports
Whether written or oral, requiring regular
reports usually suggests employee status.
Manner of payment
Being paid by the hour, week, or month suggests
being an employee, while being paid an agreed
upon lump sum for a job suggests being an
independent contractor. In addition to lump-sum
payments, employers may also utilize a straight
commission basis of compensation without
necessarily affecting the worker's status as an
independent contractor.
Payment of expenses
If an employer pays expenses, this usually means
he or she has the right to regulate and direct
business activities and indicates employee
status.
Providing tools and equipment
Independent contractors usually provide their own
equipment while employees use those belonging to
the employer.
Investment
If the worker has a significant investment in
his or her own work facilities, this implies
being an independent contractor.
Profit or loss
Independent contractors can realize a profit or
incur a loss. The risk of loss may be a result of
investments in equipment or due to a liability
for other expenses.
Multiple clients
Working for multiple clients usually
indicates independent contractor status.
Marketing
Employees don't normally market their
services to the public on a regular basis, while
independent contractors might.
Right to discharge
If the employer can discharge the worker at
any given time, this suggests employment. An
independent contractor cannot be dismissed
(without legal liability) unless the contract
specifications are not met.
Right to quit
An independent contractor may be liable for
failure to perform according to contractual
terms, while an employee may quit at any time
without liability.
Return to top
What are the risks when you misclassify
employees?
Intentionally misclassifying
employees as independent contractors may result in
penalties and interest double what should have been paid
by the business. The exposure for unintentional
misclassification of an employee is serious, but not as
serious as the risk for an intentional misclassification.
Here's what's at stake:
Unintentionally misclassifying an
employee (and the employer filed a Form 1099) limits an
employer's liability for income taxes to 1.5% of the
employee's wages. The employer's liability for FICA taxes
that should have been paid by the employee would be
limited to 20% of that amount. And, the employer would
have no rights to recover from the employee what is due
to the IRS. If an employer has not filed any information
returns, such as the Form 1099, that were required, the
percentage amounts are doubled. The employer must pay 3%
for federal withholding and 40% of the employee's portion
of FICA in addition to the employer's share of FICA.
Additionally, the employer would still be
liable for its share of FICA and unemployment taxes.
Interest and penalties could be assessed by the IRS, but
only on the amount of the employer's liability. The
employer's liability includes the percentage of tax that
should have been withheld. For example, interest for
failure to collect FICA would be based on the employer's
share of FICA plus the 20% of the tax that should have
been withheld from the employee.
Intentionally misclassifying an employee,
on the other hand, could result in the following employer
liabilities: the full amount of income tax that should
have been withheld (with an adjustment if the employee
has paid or does pay part of the tax); the full amount of
both the employer and employee shares for FICA (but might
receive an offset if the employee paid FICA
self-employment taxes); interest and penalties, computed
on far larger amounts than in the case of an
unintentional misclassification.
Return to top
Playing
it safe
When in doubt about how to classify a
worker, classify him or her as an employee. Or, seek
professional advice and ask your accountant. The hiring
firm has the burden of proving that it had no control
over the work or the worker where the worker was
classified as an independent contractor. And when a
former worker files an unemployment insurance claim, an
investigation is automatically triggered to determine the
status of the employee.
The IRS will take the 20-factor control
test to determine proper classification but will also
look to a written contract for independent contractor
classification. Any such contract should set forth the
terms of the relationship between the employer and
individual, including:
A contract between the employer and the
worker may be immaterial, however, based on the facts and
circumstances of the case.
Return to top
Common myths to avoid in classifying
workers
A hiring firm is safe if:
The Internal Revenue Service does have a
form to request a determination of status of a particular
individual, known as Form SS-8. The IRS will use the
information provided on the form, as well as any other
information that can be obtained from the other parties
involved, to determine whether an individual is covered
under the payroll tax laws.
Return to top
Safe harbors
Congress has established "safe
harbors" -- defenses -- for employers who
misclassify a worker as an independent contractor. For
example, an employer may have a defense if it had a
"reasonable basis" for not treating the worker
as an employee. This defense may apply if an employer
reasonably relied on:
Judicial precedent, published
rulings, technical advice with respect to the
taxpayer, or a letter ruling to the taxpayer.
Past IRS audits. This safe harbor
only applies if there was no tax assessment
related to the employer's treatment of
individuals holding substantially similar
positions. If no individuals were employed in
similar positions at the time of the prior audit,
this safe harbor does not apply.
Long-standing recognized practice
of a significant segment of the industry.
An employer may be denied the protection
of a safe harbor if it inconsistently classified workers
who are doing the same tasks, or if the employer has not
filed the appropriate tax forms consistent with the
treatment of a worker as an independent contractor.
Therefore, an employer is encouraged to treat all
individuals considered to be an "independent
contractor" consistently, and to file federal tax
forms as required. Check with your accountant or attorney
for professional advice in this subject.
Return to top
Independent
Contractor vs. Employee Flowchart
Checklist
Independent Contractor v. Employee Analysis
|
|
