A new business owner can quickly become overwhelmed with the various administrative, marketing, operational, and customer service tasks that running a business requires. As a business grows, one of a business owner’s first major decisions involves hiring employees. This hiring decision entails several issues, including: whether to hire part time vs. full time, provide compensation based on project vs. hourly, paying hourly vs. paying salary, and whether to hire workers as “employees” or as “independent contractors.”
Hiring staff as “independent contractors” carries many benefits, specifically when it comes to taxes. When hiring employees, employers must provide employees with IRS Form W-2 that reports of all the employee’s wages, the tax withheld by the employer, and the tax paid by the employer on the employee’s behalf (ie. FICA, Medicaid Taxes, Federal Unemployment, and Statement Unemployment). In contrast, for an independent contractor, an employer does not need to pay FICA, Medicaid, or Unemployment for the independent contractor. Instead, the employer pays the independent contractor the gross amount of money earned, issues a 1099 to the employee, and the employee is then responsible to pay his/her own self-employment tax or relevant business tax.
While the tax benefits of hiring an independent contractor are clear to an employer, the employer’s ability to classify a worker as such is much less clear. The Department of Labor and Internal Revenue Service treat the Misclassification of Employees very seriously. The Misclassification of Employees can expose an employer to substantial penalties and fines.
A common law test is used to determine whether a worker is an employee or an independent. The most important factor under the common law to determine the relationship between the employer and the worker is the degree of control the employer has over the worker. Specifically, the degree of control is analyzed through three categories: (1) behavioral control, (2) financial control, and (3) the type of relationship.
Behavioral Control covers facts that show whether the business has a right to direct and control what work is accomplished and how the work is done, through instructions, training, or other means.
Financial Control covers facts that show whether the business has a right to direct or control the financial and business aspects of the worker’s job. This includes:
- The extent to which the worker has unreimbursed business expenses
- The extent of the worker’s investment in the facilities or tools used in performing services
- The extent to which the worker makes his or her services available to the relevant market
- How the business pays the worker, and
- The extent to which the worker can realize a profit or incur a loss
Type of Relationship covers facts that show the type of relationship the parties had. This includes:
- Written contracts describing the relationship the parties intended to create
- Whether 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, and
- The extent to which services performed by the worker are a key aspect of the regular business of the company
The IRS traditionally looked at the following 20 factors:
- Instructions: If the person for whom the services are performed has the right to require compliance with instructions, this indicates employee status.
- Training: Worker training (e.g., by requiring attendance at training sessions) indicates that the person for whom services are performed wants the services performed in a particular manner (which indicates employee status).
- Integration: Integration of the worker’s services into the business operations of the person for whom services are performed is an indication of employee status.
- Services rendered personally: If the services are required to be performed personally, this is an indication that the person for whom services are performed is interested in the methods used to accomplish the work (which indicates employee status).
- Hiring, supervision, and paying assistants: If the person for whom services are performed hires, supervises or pays assistants, this generally indicates employee status. However, if the worker hires and supervises others under a contract pursuant to which the worker agrees to provide material and labor and is only responsible for the result, this indicates independent contractor status.
- Continuing relationship: A continuing relationship between the worker and the person for whom the services are performed indicates employee status.
- Set hours of work: The establishment of set hours for the worker indicates employee status.
- Full time required: If the worker must devote substantially full time to the business of the person for whom services are performed, this indicates employee status. An independent contractor is free to work when and for whom he or she chooses.
- Doing work on employer’s premises: If the work is performed on the premises of the person for whom the services are performed, this indicates employee status, especially if the work could be done elsewhere.
- Order or sequence test: If a worker must perform services in the order or sequence set by the person for whom services are performed, that shows the worker is not free to follow his or her own pattern of work, and indicates employee status.
- Oral or written reports: A requirement that the worker submit regular reports indicates employee status.
- Payment by the hour, week, or month: Payment by the hour, week, or month generally points to employment status; payment by the job or a commission indicates independent contractor status.
- Payment of business and/or traveling expenses. If the person for whom the services are performed pays expenses, this indicates employee status. An employer, to control expenses, generally retains the right to direct the worker.
- Furnishing tools and materials: The provision of significant tools and materials to the worker indicates employee status.
- Significant investment: Investment in facilities used by the worker indicates independent contractor status.
- Realization of profit or loss: A worker who can realize a profit or suffer a loss as a result of the services (in addition to profit or loss ordinarily realized by employees) is generally an independent contractor.
- Working for more than one firm at a time: If a worker performs more than de minimis services for multiple firms at the same time, that generally indicates independent contractor status.
- Making service available to the general public: If a worker makes his or her services available to the public on a regular and consistent basis, that indicates independent contractor status.
- Right to discharge: The right to discharge a worker is a factor indicating that the worker is an employee.
- Right to terminate: If a worker has the right to terminate the relationship with the person for whom services are performed at any time he or she wishes without incurring liability, that indicates employee status.
While these factors are still helpful to consider when determining whether to hire a worker as an independent contractor, the IRS now encourages a more comprehensive examination that encompasses by considering the three categories: behavioral control, financial control, and the type of relationship. Specifically, the “the IRS emphasizes that factors in addition to the 20 factors identified… may be relevant, that the weight of the factors may vary based on the circumstances, that relevant factors may change over time, and that all facts must be examined.”
More guidance is available in the IRS training manual, Independent Contractor or Employee?
For more information on the proper classification of your workers as employees or independent contractors, employment and tax compliance issues, and other related employment law issues please contact the Washington DC employment lawyers at the business law firm of Basyuk & Klaproth.
