Whenever you hire someone to help you in your business, you must determine if the person should be classified as an employee or independent contractor for tax and other purposes. Classifying workers as independent contractors is usually cheaper, but your determination is subject to review by the IRS and other government agencies.
If you misclassify an employee as an independent contractor, you could have to pay substantial back taxes, fines, and penalties.
The tax and labor law rules you must follow when hiring a worker differ depending on whether you determine that the worker qualifies as an employee or as a self-employed independent contractor (IC) under the applicable legal tests.
If you determine a worker is an employee, you must withhold income, Social Security, and Medicare taxes from the person's pay. And you must pay half the Social Security and Medicare taxes due for the employee yourself. You'll also have to pay for workers' compensation and unemployment insurance coverage for the employee.
In addition, a host of federal and state labor laws apply whenever you hire an employee. These may, for example, require you to pay employees extra for overtime, provide family leave in case of pregnancy, and provide sick leave. Larger employers must provide their employees with health insurance. You must also comply with complex and burdensome bookkeeping and reporting requirements for employees.
All of these items add enormously to the cost of hiring and keeping an employee. Typically, more than one-third of all employee payroll costs goes toward Social Security, unemployment insurance, health benefits, and vacation.
If you classify a worker as an IC, you need not comply with any of these requirements. Because they are supposed to be in business for themselves, ICs don't get the same legal protections that employees have. You need not provide an independent contractor with health insurance, paid vacation time, or any other employee benefits. All you have to do is report the amount you pay the IC to the IRS and your state tax department.
However, hiring an IC is not always cheaper than hiring an employee. Some ICs charge far more than what you'd pay an employee to do similar work.
Initially, it's up to the hiring firm to determine whether any person it hires is an employee or an IC. When is a worker an IC? Quite simply, whenever the worker is running an independent business and you treat that person accordingly. Good examples of ICs are professionals with their own practices, such as doctors, lawyers, dentists, and accountants. However, a person doesn't have to be a professional with an advanced college degree to be an IC. So long as a worker is running a business and you treat the worker as an independent business, then the worker can be an IC.
To decide whether a worker is an independent businessperson or an employee, most government agencies assess the degree of control the hiring firm has over the worker. Independent contractors maintain personal control over the way they do the work contracted for, including the details of when, where, and how the work is done. The hiring firm's control is limited to accepting or rejecting the final results of the work. An independent contractor is just that—independent.
The IRS and many other government agencies use the "right of control" test to determine whether a worker is an employee or independent contractor. The determining factor is usually whether the hiring firm has the right to control the worker. If it has the right to direct and control the way the worker performs—both as to the final results and the details of when, where, and how the work is done—then the worker is an employee. On the other hand, if the hiring firm's control is limited to accepting or rejecting the final results the worker achieves, then that person is an IC.
On the other hand, if you have the right to control how the worker does the job, that worker is an employee. This is so whether or not you actually exercise that right—that is, it doesn't matter if you decline to control the details of how the worker does the job.
And it makes no difference whether a person works only part-time. Even a part-time worker will be considered an employee if the employer has the right to exercise control.
The difficulty in applying this right of control test is that control isn't always easy to determine. Government auditors can't look into a hiring firm's mind to see if it is controlling a worker. They rely instead on indirect or circumstantial evidence indicating control or lack of it—for example, whether the hiring firm provides the worker with tools and equipment, where the work is performed, how the worker is paid, and whether the worker can be fired.
The following chart shows the primary factors used by the IRS and most other government agencies to determine if you have the right to control a worker.
Workers will more likely be considered ICs if hiring firm:
does not give them instructions
does not provide them with training
Workers will more likely be considered employees if hiring firm:
gives them instructions they must follow about how to do the work
gives them detailed training
Workers will more likely be considered ICs if they:
have a significant investment in equipment and facilities
pay business or travel expenses themselves
make their services available to the public
are paid by the job
have opportunity for profit or loss
Workers will more likely be considered employees if:
hiring firm provides them with equipment and facilities free of charge
hiring firm reimburses their business or travel expenses
they make no effort to market their services to the public
hiring firm pays them by the hour or other unit of time
they have no opportunity for profit or loss—for example, because they're paid by the hour and have all expenses reimbursed
Relationship Between Hiring Firm and the Worker
Workers will more likely be considered ICs if:
they don't receive employee benefits such as health insurance
they sign a client agreement with the hiring firm
they can't quit or be fired at will
they perform services that are not part of hiring firm's regular business activities
Workers will more likely be considered employees if they:
receive employee benefits
have no written client agreement
can quit at any time without incurring any liability to hiring firm
can be fired at any time
perform services that are part of hiring firm's core business
Some states have adopted special rules defining when workers qualify as independent contractors. These rules apply only to state laws, including state workers' compensation, unemployment, and labor laws. For example, California passed a law called AB 5 that governs how California workers must be classified for purposes of the state's minimum wage, overtime pay, unemployment insurance, workers' compensation insurance, family medical leave, and labor laws.
Your decision about how to classify a worker is subject to review by various government agencies, including:
These agencies work independently of each other. If the IRS or other government agency determines that a hiring firm has misclassified an employee as an IC, it can order the firm to treat the worker as an employee and require it to pay back taxes and substantial penalties. Being ordered to pay massive amounts of back taxes and penalties can easily put a small company out of business. Being reclassified is not necessarily great for the worker either--he or she could lose valuable business tax deductions.
Moreover, several states have laws that make it fraudulent for an employer to "knowingly" misclassify its workers as ICs to avoid providing them with unemployment or workers' compensation insurance, or to avoid having to comply with federal or state wage and overtime pay rules.
You could also get sued by your workers for employee misclassification. Many of these take the form of class action lawsuits in which plaintiffs' lawyers represent tens, hundreds, or even thousands of similarly situated workers. The plaintiffs in these cases seek payment for unpaid wages or employee benefits, such as minimum wages, overtime pay, sick leave, health benefits, and vacation pay. In recent years, many workers have filed these lawsuits, including truckers, FedEx delivery workers, Uber and Lyft drivers, insurance agents, janitors, telecommunications support personnel, healthcare professionals, "crowdsourced" workers, and even exotic dancers.