The answer is “sometimes.” First know that you’ve got to call this one right. If you make the wrong decision, you can wind up personally liable for a lot of taxes! And potentially lots of other costs!
Many small business owners hire occasional help and don’t want the bother of treating them like a regular employee. They don’t want to have to do a regular payroll and pay and withhold taxes on the amounts paid. Truthfully, a payroll can be a bother, and sometimes it is an unnecessary expense.
Employees are covered by employment and labor laws. Owners may be tempted to treat employees as independent contractors in order to avoid unemployment taxes, worker’s compensation benefits, and other liability.
There are many benefits to using contractors over hiring employees:
- Savings in labor costs
- Reduced liability
- Flexibility in hiring and firing
However, misclassification of a worker as an independent contractor may have a number of costly legal consequences. If your independent contractor is discovered to meet the legal definition of an employee, you may be required to:
- Reimburse them for wages you should’ve paid them under the Fair Labor Standards Act, including overtime and minimum wage
- Pay back taxes and penalties for federal and state income taxes, Social Security, Medicare and unemployment
- Pay any misclassified injured employees workers’ compensation benefits
- Provide employee benefits, including health insurance, retirement, etc.
What’s the difference between an employee and an independent contractor?
Generally speaking a worker is more likely an independent contractor if he/she: operates under a business name, maintains a separate business checking account, advertises his/her business’ services, invoices for work completed, has more than one client, has his/her own tools or equipment, sets his/her own hours and keeps business records.
For tax issues, the IRS has always used the so-called “20-factor test” to determine if a worker is an employee or an independent contractor. This test is used to assess the degree of control the company exercises over the way the work is performed by the independent contractor. If the company exercises too much control, the worker is deemed to be an employee. Employers do not have to pay FICA (social security and Medicare) and FUTA (federal unemployment insurance) taxes on independent contractors, nor do they have to withhold federal income taxes for these individuals.
The IRS, which estimates that it loses billions in tax revenue each year due to misclassification of employees as independent contractors, has cracked down on the problem in recent years. They have revised the criteria into 11 general categories that fall into 3 different subject areas:
1. Behavioral Control. Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of:
- Instructions that the business gives to the worker. An employee is generally subject to the business’ instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work: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, and what order or sequence to follow.Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker’s performance or instead has given up that right.
- Training that the business gives to the worker. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.
2. Financial Control. Facts that show whether the business has a right to control the business aspects of the worker’s job include:
- The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform for their employer.
- The extent of the worker’s investment. An independent contractor often has a significant investment in the facilities or tools he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.
- The extent to which the worker makes his or her services available to the relevant market. An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.
- How the business pays the worker. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. An independent contractor is often paid a flat fee or on a time and materials basis for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.
- The extent to which the worker can realize a profit or loss. An independent contractor can make a profit or loss.
3. Type of Relationship. Facts that show the parties’ type of relationship include:
- Written contracts describing the relationship the parties intended to create.
- Whether or not the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay.
- The permanency of the relationship. If you engage a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that your intent was to create an employer-employee relationship.
- The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of your regular business activity, it is more likely that you will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.
If you are a small business owner, this is an important decision and you shouldn’t rely on the assertion of a worker that he/she’s “ok with being an independent contractor” or that he/she “has his own business.” It’s the owner’s responsibility (and potential liability) if a mistake is made.
Do not underestimate the difficulty of applying these standards to specific individuals performing services for your business. In doubtful cases, always consult an attorney.