Be careful in determining whether a worker is an employee or an independent contractor - there are serious consequences for getting it wrong

Small businesses often want their workers to be independent contractors rather than employees for a number of reasons:

Important Tip It is important to have a clear and carefully worded agreement in place with the independent contractor to make sure the desired status is clear and to help support the determination.

No employment taxes. Employment taxes do not need to be paid on payments to independent contractors.

No withholding. Withholding usually does not need to take place for independent contractors (income, social security and Medicare).

Fewer legal requirements. A small business can avoid certain laws with respect to the independent contractor like workers' compensation laws and minimum wage and overtime payment laws.

Fewer benefits. An independent contractor is often not eligible for the small business' benefit plans for employees.

Less liability. A small business is less likely to be liable for any improper actions by the independent contractor (such as a car accident or acts causing injuries).

Because of the big differences between an employee and an independent contractor in the above matters, there are many cases and laws that help decide whether a person working for a small business is an employee or an independent contractor. These cases and laws have created a number of factors that will be considered in determining whether a person is an independent contractor or an employee. The Internal Revenue Service has provided the following guidance in determining whether a person is an employee or an independent contractor:

Worker Classification

Employers must withhold Social Security and income taxes from employee paychecks. Conversely, independent contractors are responsible for reporting and paying their own Social Security and income taxes.

Businesses use several factors to determine how to classify its workers, including the degree of control the business has over its workers. Generally, the more control the business has over a worker, the more likely it is that the worker is an employee rather than an independent contractor.

Facts that provide evidence of the degree of control and independence fall into three categories:

  • Behavioral control
  • Financial control
  • Type of relationship

Behavioral control relates to whether the business has a right to direct and control how the worker performs the task for which they are hired. In general, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that the employer has the right to control the details of how the services are performed. Such details include:

  • When and where to do the work
  • What tools or equipment to use
  • What workers to hire or to assist with the work
  • Where to purchase supplies and services
  • What work must be performed by a specified individual
  • What order or sequence to follow

Financial control looks at whether a worker has the ability to affect financial decisions. Does the worker have a significant investment in assets or tools? Are there unreimbursed expenses that the worker has to bear themselves? Are the worker's services available to the public? What is the method of payment; do they get paid whether the work is done or not or do they get paid only if they finish the job? Independent contractors can realize a profit or loss on a job. Can the worker make business decisions that affect his bottom line?

Relationship of the parties looks to whether or not there is a contract between the worker and the business and how it is worded; whether the worker gets any type of benefits — vacation and sick pay, pension plan, and health or life insurance; and the permanency of the relationship such as continuing indefinitely or only for a specific project or period. Also, does the worker have his own business, which he markets to others?

If you want the IRS to determine whether a specific individual is an independent contractor or an employee, file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. Employment Taxes and Classifying Workers FS-2007-27 (December 2007)

Additional Information
Important Tip: 
It is important to have a clear and carefully worded agreement in place with the independent contractor to make sure the desired status is clear and to help support the determination.
Marketing copy: 
Independent Contractor Agreements