Employee vs. Contractor
By Christopher Marini, MSA, MOS
One of the most exciting moments for any small-business owner is reaching the point of having sufficient demand and capital to need additional help. Many businesses benefit from hiring employees, whereas others function better utilizing independent contractors. Generally, most businesses have a need for both employees and independent contractors.
The most noticeable difference between these classifications is how they are paid. Employees are part of the payroll, and accordingly the employer is also required to pay certain payroll taxes as well as workers’ compensation insurance. In contrast, independent contractors are not part of the payroll, and are typically paid through accounts payable. Following the end of the year, employees must be given a W-2, and all independent contractors who were paid $600 or more must be sent a 1099-MISC.
Determining whether to pay an individual as an employee or independent contractor requires the business owner to understand the distinguishing differences in classification. Failure to do so could have detrimental financial consequences. Under IRS regulations, classification at the federal level follows ‘common-law rules,’ which consist of three categories: behavioral, financial, and type of relationship. Here are some specifics:
Behavioral control relates to the degree of oversight by the employer. If the worker is subject to employer instructions, this tends to be indicative of an employee. Pursuant to IRS Publication 15-A, examples of “instructions” include:
• When and where to do the work;
• What tools or equipment to use;
• What additional workers to hire or to assist with the work;
• Where to purchase supplies and services;
• What work must be performed by a specified individual; and
• What order or sequence to follow when performing the work.
Other behavioral factors to consider are whether the worker undergoes training or periodic evaluations. Both of these circumstances would point to the need for an employee classification.
Independent contractors generally have much more complex financial structures. For example, independent contractors often have a significant personal investment in equipment needed to perform their work. Often, their service is for a short-term period of time, and they perform similar services for several other consumers. Because of this, they often have various unreimbursed expenses.
In terms of pay, independent contractors are typically paid a flat fee for their service, whereas employees are usually paid a wage based on hours worked. Because employees are paid a wage, and don’t typically have significant investments in equipment or unreimbursed expenses, employees are guaranteed a profit.
However, independent contractors incur the possibility of having a loss if expenditures exceed the fee they collect for their service.
Type of Relationship
One important relationship factor is permanency. Workers who are hired for an indefinitely continued period of time are typically employees, whereas workers hired for a specified period, or until a particular project is completed, are generally considered independent contractors. Employers should be cautioned that the behavioral or financial rules could cause temporary or seasonal workers to be classified as employees.
Another important factor to consider is whether the service being provided is considered a key activity of the business. Workers performing activities that are major components of a business’ offered services are typically employees. Independent contractors typically perform services that are outside the realm of key activities.
Consider State Rules
Certain states have their own sets of rules, which may differ from the federal laws, so be sure to consider if there are any significant differences. For example, Massachusetts has established the Massachusetts Independent Contractor Law, which is even stricter than the federal laws. Under the Massachusetts regulations, workers, by default, are assumed to be employees unless the employer can pass a ‘three-prong test,’ which, similarly to the federal regulations, examines control and nature of the service being provided.
Although rare, it is possible that a worker could be classified as an independent contractor per federal laws and as an employee per state laws. In Massachusetts, this unique situation would result in the need for an employer to pay state unemployment tax, even though the employer is not paying any federal payroll taxes.
If an employer has improperly classified an employee as an independent contractor, they may be held liable for the payroll taxes that they have not paid. The IRS has implemented a Voluntary Classification Settlement Program, which offers partial relief in back taxes owed in exchange for prospectively reclassifying employees previously classified as independent contractors. Additionally, misclassifying employees as independent contractors could carry penalties related to other benefit plans as well as workers’ compensation issues.
If, after consideration of all of the above information, it is still unclear which classification is appropriate, Form SS-8 can be filed with the IRS. Using this method, the IRS will consider the facts provided to make the appropriate determination. However, this process typically takes more than six months, according to the IRS website, so seeking advice from an accountant or lawyer may prove to be the most efficient method.
In any event, knowing these rules will prove to be a tremendous asset, both in the present and in the future. Classification of workers is an important procedure for small businesses beginning operations, as well as for more established businesses. Understanding the regulations allows employers to operate more efficiently and effectively and could help them avoid future problems.
Christopher Marini, MSA, MOS is senior Auditing & Accounting associate at Meyers Brothers Kalicka, P.C.; (413) 322-3549; firstname.lastname@example.org.