Contractor or employee? The difference matters – a lot. Be sure you’re using the correct classifications for your staff.
Employees. Contractors. They both create and support products or provide services for your customers. They’re your company’s most valuable assets.
But the IRS looks at each very differently. And when you hire people and start dealing with their compensation, you, too, need to be very sure that you classify them correctly for income tax purposes.
You probably already know the primary difference between them. You only pay contractors or freelancers a fee for their contributions. With employees, you’re also responsible for employment taxes and often other benefits.
Control and Independence
The IRS itself states that, “… there is no ‘magic’ or set number of factors that ‘makes’ the worker an employee or an independent contractor.” And you can’t use just one factor to make the determination. For example, you can’t call an individual an independent contractor simply because he or she works out of a home office instead of yours. Rather, you have to look closely at the whole relationship between your company and them. You need facts. You need to consider the “…degree of control and independence” involved, in three different categories.
Do you as the employer have the right to control how the individual works? There are four ways to measure here:
1. Type of instructions given. Do you tell the individual how, when, and where to work? What equipment to use? Where to buy supplies and services? What sequence to follow?
2. Degree of instruction. How detailed are the instructions?
3. Evaluation system. Is the employee evaluated on how the work is done or just the end result?
4. Training. Do you offer initial and periodic training, or is the individual responsible for his or her own?
There are several questions to consider here. Does the individual:
Pay for a significant percentage of the equipment used?
Have a lot of unreimbursed expenses?
Have the opportunity to make a profit or loss?
Feel free to work for other businesses?
Generally receive consistent wages for each pay period?
Type of Relationship
How would you and the individual characterize your relationship with each other? Is there a written contract? Employee benefits? Did you hire him or her expecting that the relationship would go on indefinitely? Are the individual’s contributions to the company a “key activity” of the business?
As you can see, it’s more complicated than you might think. The IRS takes this issue very seriously, and has been known to follow up with companies where at least some of the classifications were suspected to be in error.
If you still can’t determine whether an individual is an employee or independent contractor after going through all the above questions, you–or someone who works for you–can complete and file an IRS Form SS-8. This is a rather lengthy document designed to help determine a worker’s employment status.
We’re always available to consult with you on various issues of tax law, and this is an important one. Though a situation may seem cut-and-dried to you, don’t be afraid to ask.