One of the most visited pages on the SmallBusiness.com WIKI is an entry on the topic of determining whether or not someone who is providing services to a company is an employee or an independent contractor. It’s a critical topic for both the business obtaining the services and the business (or sole proprietor) providing the services. Why? Because the way in which taxes are paid and certain benefits are allocated hinge on whether or not the provider is determined by the IRS and other federal and state agencies to be an employee or independent contractor.
Note: When it comes to issues related to taxes and the law, you should always consult your company’s legal and financial advisors before making a decision.
In many cases, it’s easy to know that a service provider is an independent contractor: You hire a freelancer to write copy for a brochure, you pay a bookkeeper to spend a few hours each month to assist on an accounting need, you hire a painter to repaint a room in your building. In those examples, it is easy to classify the service provider as an independent contractors.
However, there are many situations in which determining the difference in employee and independent contractor can become more confusing, and in some cases, contentious.
Why it’s critical to correctly determine whether a service provider is an employee or an independent contractor
Whether or not someone is an employee can have an impact on a wide array of federal, state and local regulations and taxes. Everything from tax withholding to employee benefits to wage and hour guidelines (minimum wage and overtime issues) are determined by the status of the relationship between the company and service provider. State and federal agencies have joined together to, in the words of the Department of Labor, “combat (the) pervasive issue” of employees misidentifying employees as independent contractors. Use of the word “combat” indicates that the Department of Labor views finding businesses misidentifying employees as a war. In such a war, it is important for a company to clearly determine its relationship to all those providing it services that may fall into a gray-zone.
Common law rules for determining the difference in an employee or an independent contractor
In general, there are three areas (or, “common law” rules) that determine if someone providing your company a service is an employee. All are related to how much control the business has over the provider.:
Behavioral factors: These factors relate to how much control the company has over what the worker does and how the worker does his or her job. For example, if the business hires a free lancer to provide a certain number of articles for a newsletter, that would be an independent contractor. If, on the other hand, the company required the freelancer to write those articles between 8 a.m. to 5 p.m. at a specific office using the company’s computer, the designation of independent contractor would be harder to defend.
Financial factors: Are the business aspects of the worker’s job controlled by the payer? These include things like how worker is paid, whether and how expenses are reimbursed, who provides tools/supplies, etc.
Relationship factors: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work being performed a key aspect of the business? If it is, the relationship will more likely be judged a business-employee one.
According to the IRS, there is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors relevant in one situation may not be relevant in another. The keys are looking at the entire relationship, considering the degree or extent of the right to direct and control, and finally, documenting each of the factors used in coming up with the determination.
When in doubt, you can request a determination from the IRS
As noted above, you should never make decisions related to taxes or regulations without consultation with your legal and financial advisors. However, the IRS does provide the option to businesses to seek a ruling on an employee’s status by filing a Form SS-8 (PDF), “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” The form may be filed by either the business or the worker. The IRS will review the facts and circumstances and officially determine the worker’s status.
Be aware that it can take at least six months to get a determination. And once a determination is made (whether by the business or by the IRS), the next step is filing the appropriate forms and paying any associated taxes the ruling may require.
Did we mention that you should seek guidance from your legal and financial advisors when doing this? Even if we did, it’s worth repeating.
Resources related to this topic:
- IRS.gov: “Independent Contractor (Self-Employed) or Employee?”
- Department of Labor (DOL.gov): Employee Misclassification as Independent Contractors