Employees Versus Independent Contractors

Anyone who works for your business (other than a business owner) is either an employee or an independent contractor (IC). In a nutshell, an employee is someone who works for you, on your site, with your tools and equipment, and according to your rules and procedures. Independent contractors, on the other hand, are in business for themselves; they work on their own time and with their own tools, and perform services for a number of different clients.

This is not a distinction to be taken lightly. Businesspeople who hire employees owe a number of employment taxes, such as payroll tax and unemployment tax, while those who hire only independent contractors do not owe these taxes. If you treat an employee as an independent contractor and fail to pay employment taxes, you risk subjecting yourself to a huge back-tax bill, plus interest and other state and federal penalties. More than a few businesses have been torpedoed and sunk into bankruptcy after making this mistake.

With that warning in mind, here's the lowdown on classifying your workers.

The Agencies That Matter

Because paying taxes is the main drawback to classifying workers as employees, it shouldn't surprise you to learn that the IRS takes a great interest in whether your workers are classified properly. At the federal level, the IRS will take swift and severe action if it finds out that you're treating a worker as an independent contractor when in fact that worker meets the criteria of an being an employee. At the state level, there are rules for classifying workers that may be stricter than or otherwise different from the IRS rules. The penalties at the state level can be at least as harsh as those imposed by the IRS, so be sure you understand the rules in your state. The state agency in charge of worker status rules and enforcement is generally an employment agency, tax department, unemployment office, or other employment-related bureau.

IRS Criteria

The IRS's Publication 15-A, Employer's Supplemental Tax Guide, offers information and examples to help you determine whether a worker is in fact an independent contractor or an employee. It is available online at www.irs.gov/formspubs/index.html.

A worker should normally be considered an employee, not an independent contractor, when he or she:

  • works only for you and not for any other business
  • works on your premises
  • uses your tools and equipment
  • follows work hours you set
  • follows your instructions on how to complete a job
  • receives reimbursement for expenses incurred in doing a job
  • supervises any of your other workers, or
  • receives any employee benefits, such as holiday pay, vacation time, or health insurance.

On the flip side, a worker should probably be considered an independent contractor if he or she:

  • works for a number of different businesses or clients
  • has a personal office, studio, garage, or other permanent place to work
  • owns equipment and tools used for the work
  • sets his or her own hours
  • uses independent judgment as to how best to complete a job
  • doesn't get reimbursed for expenses incurred in doing a job, or
  • advertises services to the public.

Of course, a worker you hire might display some characteristics of both categories, which makes it harder to say for sure how that worker should be classified. Ultimately, you'll need to consider these factors all together and weigh them against each other to decide whether a worker should be classified as an employee or as an independent contractor.

In borderline situations, it's safer to treat a worker as an employee than risk the penalties that may result if the IRS or your state decides you've misclassified an employee as an independent contractor. Keep in mind that the IRS and most state authorities tend to disfavor independent contractor status. They'd much rather see borderline workers classified as employees so that they can collect taxes on them.

If you can't decide how one of your workers should be classified, there are a few ways you can proceed. One is to consult a lawyer or an accountant who understands business tax laws. Another option is to go straight to the horse's mouth and ask the IRS or your state agency to tell you how they would classify a certain worker. You can file Form SS-8, Determination of Worker Status, to request a formal ruling from the IRS on a worker's status. You can get this form from an IRS office or from the agency's website at www.irs.gov. However, don't be surprised if the IRS classifies your worker as an employee.

For a state determination, contact your state employment or other agency that governs worker classification and find out what procedure it uses. Like the IRS does, it's common for states to classify workers as employees rather than independent contractors. You'll have to decide for yourself whether it makes sense to leave the determination up to these agencies, or whether you feel confident enough to classify your workers on your own.

Excerpted from The Small Business Start-Up Kit: A Step-by-Step Legal Guide, by Peri Pakroo (Nolo).

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