Before you can determine whether an individual providing services should be treated as an employee or an independent contractor, you must consider all the relevant facts regarding the degree of control you have over the worker and the amount of independence the worker has.
These relevant facts fall into three main categories: behavioral control, financial control and the relationship of the parties. In each case, it is important to consider all the facts, as no single factor provides the answer.
Behavioral control
Do you have the right to direct and control the worker? If so, this indicates that the worker is your employee. For example, if you give extensive instructions on how work is to be done, this suggests that you are an employer and the worker is an employee. Instructions can cover a wide range of topics, including the following:
• How, when or where to do the work
• What tools or equipment to use
• What assistants to hire to help with the work
• Where to purchase supplies and services
Financial control
Do you
control the business aspects of the worker's job, such as how he or she is being paid, whether expenses are reimbursed and who provides tools/supplies? If the worker has a significant investment
in the work, the worker may be an independent contractor. While there is no precise dollar test, the investment must have substance. If the worker is not being reimbursed for some or all business
expenses, this indicates that the worker may be an independent contractor, especially if unreimbursed business expenses are high. Additionally, if the worker can realize a profit or incur a loss,
this suggests that the worker is in business for him- or herself and may be an independent contractor.
Relationship of the parties
If you are paying benefits to a worker, such as insurance, pension or paid leave, this indicates that the worker is your employee. However, if the worker is not receiving benefits, that is not necessarily determinative of his or her employment status. A written contract may be useful to show what both you and the worker intend and can be helpful in situations where it would be difficult, if not impossible, to determine the employment status of a worker based on other facts.
Because such employment contracts will often contain a number of legal terms and conditions about the working relationship between you and the worker, it's advisable to consult a lawyer who specializes in employment law to draft such a contract.
W-2 workers versus 1099 workers
Some employers prefer to hire independent contractors to get around having to pay or withhold employment-related taxes and file Forms W-2 for employees at the end of the year. As an employer, you are subject to employment taxes based on wages paid to employees. These taxes include those imposed by the Federal Insurance Contributions Act, the Federal Unemployment Tax Act and income tax withholding on the employee's wages. An employer must then make periodic deposits of (1) amounts withheld from employees' wages and (2) the employer's share of FICA and FUTA taxes.
The payroll tax regulations are complex, and the penalties can be stiff for not depositing payroll taxes timely or depositing incorrect amounts. If you intend to hire employees, hiring a payroll tax specialist should also be on your to-do list to ensure your business accurately calculates and timely files payroll taxes. IRS penalties for failing to timely make payroll tax deposits or failing to deposit the correct amounts can be extensive enough to put an employer out of business.
When a worker is classified as an independent contractor, the business may be required to give the worker a Form 1099-MISC, Miscellaneous Income, to report what has been paid to the worker. The worker is then responsible for paying his or her own income and self-employment taxes and may need to make estimated tax payments during the year to cover his or her tax liabilities.
However, as an independent contractor, the worker may deduct business expenses on Schedule C of Form 1040. Such expense deductions aren't generally available to a W-2 employee.
What happens if you misclassify a worker?
If you classify an employee as an independent contractor and you have no reasonable basis for doing so, then you can be held liable for the employment taxes for that worker as well as substantial penalties. Thus, correctly categorizing your workers is important to avoid these additional expenses.
Work with qualified human resources and accounting professionals to make sure you're classifying all your employees correctly.