Employees vs. Independent Contractors

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.

Importance of Classifying Workers

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.

How to Classify Workers

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.

IRS Test for Worker Status

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.

Consequences of Misclassifying a Worker

Your decision about how to classify a worker is subject to review by various government agencies, including:

• the IRS
• your state unemployment compensation agency
• your state workers' compensation agency
• your state tax department (if your state has income taxes)
• the U.S. Department of Labor
• the National Labor Relations Board, and
• your state labor department.

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.