At some point in time, a business owner has to decide whether to seek help growing their business. They may need employees or independent contractors or both for the business to grow.

A business hires an employee to perform a specific task or tasks. So is a contractor. The difference depends on several factors, but the reason is specific.

The Difference between an Employee and Independent Contractor

The Internal Revenue Service reminds small businesses of the importance of understanding and correctly applying the rules for classifying a worker as an employee or an independent contractor. For federal employment tax purposes, a business must examine the relationship between it and the worker. (Emphasis Added)

The sole reason this distinction is important is due to the requirement of employers to withhold, match and remit Social Security and Medicare taxes and pay unemployment taxes to the IRS on the wages of an employee. There is no such requirement for amounts paid to an independent contractor.

Employees can be expensive, and managing the payroll function can be confusing and time-consuming. In addition to wages, the employer, as mentioned above, is also required to pay taxes on the wages paid.

Not only is the employer taxed, but the IRS is also effectively making them the tax collector. Many employers see treating workers as independent contractors as a cost-effective and straightforward solution to these issues.

Independent contractors are responsible for paying their own income, Social Security and Medicare (but not, in most instances, unemployment) taxes so there is less expense and no need to withhold or pay taxes on the amounts paid by the employer.

If there were no employees, it would be challenging to collect the taxes needed to operate the government and fund the retirement programs. Unfortunately, the IRS is aware of this. As a result, they have provided guidelines to employers to help them determine whether the worker is an employee or an independent contractor.

Employee vs. Contractor

The IRS identifies two broad concepts to help employers classify workers.

Control. Specifically, the IRS refers to “behavioral control” and “financial control”. Questions to be answered include:

  • Who owns the tools, equipment or facilities used to complete the work?
  • Who determines how the work will be completed? 
  • Is any training required?
  • Does the worker hold themselves out to the market in general or do they work exclusively for the employer? (i.e. are they in business for themselves?)
  • Is payment made on a regular schedule and for a regular amount (i.e. a salary or wage) not specified in a written contract?
  • Does the worker incur a financial risk?

Relationship. How the employer and the worker view their relationship.  

  • Is there a written contact specifying the relationship and the work to be done?
  • Are any benefits provided by the employer to the worker?
  • Are the services provided a “key aspect” of the normal operation of the business?
  • Is the worker reimbursed for their expenses?

IRS Rules on Employees and Independent Contractors

The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done. Small businesses should consider all evidence of the degree of control and independence in the employer/worker relationship. Whether a worker is an independent contractor or employee depends on the facts in each situation.

It is usually the employer’s responsibility, then, to determine this relationship based on these factors. There is also a Form SS-8 “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding” that an employer can submit to the IRS who will determine them if they aren’t sure.

The employer should realize that normally the IRS isn’t going to know about the classification except in certain situations. If the IRS audits the employer for any reason, they will look at the relationship. Audits can be random or triggered by certain events. These include:

  • The worker gets audited or doesn’t pay their taxes
  • The worker decides to file for unemployment (a sure sign that they are probably an employee)

In this situation, the employer faces some potentially serious consequences.

Consequences of Misclassification

If the IRS determines a worker or workers are misclassified, the employer who paid them will be required to pay the employer’s share of the Social Security and Medicare taxes and the Federal Unemployment taxes on the amounts paid plus penalties and interest.

Depending on the time frame and the amounts paid to the worker, this can become significant. They will work out a payment plan if necessary but certain rules apply. 

When this happens, it is best to consult a professional, such as a Certified Public Accountant or Enrolled Agent who can represent you in any discussions or negotiations with the IRS.

The misclassification can also lead to state tax liabilities.

Pros and Cons

Moreover, a primary concern for employers who choose to classify their workers as independent contractors is that the worker may file an unemployment claim if the employer no longer requires their services.

Independent contractors are generally not entitled to unemployment benefits if self-employed as nothing has been paid in for them. They aren’t required to pay it for themselves except in certain circumstances (in which case they would almost certainly be classified as a contractor).

It would be almost impossible to classify a worker as an employee in a state and an independent contractor for IRS purposes. However, the act of filing for the benefits, generally done with the state they live in, will undoubtedly incur scrutiny by the unemployment office in that state. It can, even though state auditors tend to deny it, lead to the IRS finding out.

The state or states that the employer operates in can also be significant. Despite what their website says, California has virtually eliminated the independent contractor classification through legislation even though the worker might otherwise qualify as a contractor in another state or for IRS purposes.

Final Thoughts from a Professional

Classifying a worker as an employee or independent contractor is a business decision that can have both benefits and serious consequences. The best approach is to evaluate each situation individually. Also, consult with legal and tax professionals to determine the best treatment. 

The prudent business owner will not make this decision solely to save money as it could become significantly more expensive if the classification turns out to be wrong in the eyes of the IRS or a state taxing agency.