Let’s focus on a business issue common to U.S. business owners today — are your workers employees or independent contractors (and really, what does that mean anyway)?
Basically an employee is, as the IRS puts it, “anyone who performs services for you… 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 you have the right to control the details of how the services are performed.” [source]
On the other hand, an independent contractor (or freelancer) is a self-employed individual. You’re not their employer. You’re they’re client — usually one of several. You can determine the end result you’re looking for and hire a service provider to do that work for you, but you cannot control how that work is actually done as long as they meet their contracted terms, like a deadline.
Why It’s Important to Classify Workers Correctly
Here’s a good reason to classify your workers correctly: if you don’t, you might find yourself dealing with the IRS. No one wants that, right?
When you hire someone as your employee, you take on certain obligations. That includes withholding income tax, withholding and paying Social Security and Medicare taxes, and paying unemployment tax based on the wages paid out. When you hire an independent contractor, they’re responsible for their full income tax, Social Security, and Medicare payments.
Don’t think that you can hire a worker, exercise an employer-like level of control over them, and simply classify them as an independent contractor to try to save money though. Try it, and you might find yourself with a huge tax bill down the road when the IRS finds out.
It’s a give and take option. If you want the added control employers have over workers, then you’ll pay more. If the worker wants more freedom (by being self-employed and outsourcing their services), then they take on those financial burdens.
How to Determine Employee or Independent Contractor Status
Unfortunately there are no hard and fast rules that say so-and-so is definitely an employee or an independent contractor. Instead there are common law rules from the IRS. These rules fall into three categories:
- Behavioral
- Financial
- Type of relationship
Behavioral Factors
If you can do some or all of the following things on the behavioral end, then your worker probably leans towards employee status:
- Tell the worker when and where to work
- Tell the worker what specific equipment or tools they have to use in their work
- Control the hiring or choosing of subcontractors (or insisting all work be done solely by that worker)
- What order to do your work in
- Where they have to purchase supplies necessary to complete your project
This all comes down to instruction — how much are you able to tell the worker what to do? If you give very detailed instructions they have to follow, you’re exercising a lot of control, and lean towards employer status instead of being a client — for example, giving detailed training. How you evaluate the work done also matters. Do you just evaluate the end result to be sure it meets your needs? Or do you supervise the worker, evaluating them on how they get the job done (think micromanaging behavior like actually watching the service provider as they complete their work)? Evaluating based on how the work is done, as opposed to simply what’s delivered, leans towards employer status as well.
Financial Factors
Being able to control where, when, and how a worker gets their job done isn’t all you have to consider. You also have financial factors you need to look at.
For example, does the worker have to invest a significant amount of their own money in equipment? It might lean towards them being an independent contractor (although not always). If you reimburse most, or all, expenses then that leads to them more likely being an employee.
Does the worker have an opportunity for both profit and loss? This is important, because workers who have a significant opportunity for financial loss are likely independent contractors technically in business for themselves.
How much do your payments control the financial situation of the worker? Do they work only for you, either full-time or part-time? Or are they able to market their services to other buyers / clients? If they’re able to seek other clients at the same time, there’s a better chance that they’ll fall under the independent contractor status.
There’s one more thing to look at on the financial side of things — how are they paid? Do you pay them a guaranteed salary or an hourly wage? Then they’re probably employees. Do you pay them on a per-project basis? Then they’re likely independent contractors. It’s not a concrete rule though. Some independent contractors (such as consultants) bill on an hourly basis as well.
Type of Relationship
Are you confused yet? Well, hang in there. There are a few other factors you have to look at when determining employee or independent contractor status for your workers. They revolve around the type of relationship you have with each other.
For instance, if you pay employee benefits (like insurance or paid vacation time), then your worker is most likely going to be considered an employee by the IRS. If you expect the worker to be a permanent part of your business, that would lead to the same conclusion in many cases (whereas you might hire an independent contractor for a 3-month contract or to finish one specific job — it’s not ongoing on an indefinite basis).
It gets even more complicated. You have to consider how integral the worker’s services are to the overall business. If it’s a key component of the business then you likely have the right to exercise more control over those services and how they’re carried out, and therefore you would lean towards employer status.
Sorting it All Out
Sheesh! Who ever would have thought the IRS could make something so complicated? (Yeah, I know… ha ha.) You might be thinking “No problem, I’ll just have the worker sign a contract saying they’ll be independent contractors and that they’ll be responsible for the taxes.” Sorry loves. It doesn’t work that way. No matter what your contract says, it comes down to the factors listed above. The IRS can determine the worker is an employee regardless of the contract terms. (And as a freelancer, I find that almost comforting — it means buyers can’t pressure workers into taking on the extra financial burden of added taxes while still trying to exercise undue control.)
Remember, this is a very subjective area. There aren’t a lot of clear-cut rules. Having one factor be true for you doesn’t mean the decision will absolutely go one way or the other. It’s about the collective behavioral and financial relationship between you and your workers.
If you’re really uncomfortable making the determination of independent contractor or employee, you can let the IRS do it for you. Just fill out and send in IRS Form SS-8 (either you or the worker can do this). At least then there won’t be any question. You’ll know exactly what taxes and other expenses you’re responsible for.
