Confusing Employees and Independent Contractors: A Costly Risk

Employees and independent contractors are not the same, and the difference isn’t just that employees are on your payroll and independent contractors are not.

It’s also not just that employees should sign employment agreements and independent contractors should sign independent contractor agreements.

And it’s definitely not that you don’t have to provide medical benefits to independent contractors.

You need to know the critical differences between employees and independent contractors based on the IRS’ classifications or you could find your business in serious and extremely expensive trouble in the form of fines, penalties, and interest that could cost hundreds of thousands of dollars. That’s more money than most small businesses can afford to pay, so you need to make sure that everyone who provides services to your company is correctly classified as either an employee or independent contractor.

Generally speaking, there are three main characteristics that the IRS and Department of Labor (DOL) use to determine employment status:

1. Behavioral Control

First, the IRS and DOL look at how much control your business has over a worker’s behavior. This is done by determining if your business directs or has control over how the person actually performs the work through instruction, training, or any other means.

For example, if workers are expected to follow very specific instructions to perform their work using specific equipment or are trained to follow specific processes, then they’re probably employees. Companies can’t control how independent contractors perform work with specific instruction or training.

Additionally, companies can’t control how independent contractors perform their work with regard to the equipment they use or which hours during the day they work.

2. Financial Control

Next, the IRS and DOL review whether or not your business directs or has control over the financial and business aspects of a worker’s job.

For example, if workers are expected to work with specific vendors, to not work with other clients (or only to work with certain other clients), or to manage finances in a specific way, then they’re probably employees. Companies can’t control what independent contractors do with their money or their own businesses.

Furthermore, independent contractors typically have a significant investment in the tools they use and in growing their businesses. To that end, they offer their services to multiple clients. If you’re a worker’s only client, then that worker is probably an employee.

3. Type of Relationship

Finally, the IRS and DOL review how both you and the worker perceive your working relationship.

For example, if a worker is providing a high number of working hours to your company and is performing tasks that are a key aspect of the regular business of the company, then that person is probably an employee.

You can find more details in IRS Publication 15-A Employer’s Supplemental Tax Guide.

Employee Characteristics

To help you classify your workers, consider the following characteristics that most employees share:

  • Employees have specific duties that the employer defines.
  • Employees perform work that the employer controls.
  • Employees are trained by the employer to do the work they perform.
  • Employees work for one employer only.

Independent Contractor Characteristics

  • Independent contractors are business owners (whether they realize it or not).
  • Independent contractors often operate under a separate business name.
  • Independent contractors provide invoices for the work they perform.
  • Independent contractors choose their own hours.
  • Independent contractors often have separate business and personal records and financial accounts.
  • Independent contractors often have their own employees.
  • Independent contractors perform temporary work.
  • Independent contractors have written contracts (or at least, they should).

Avoid Misclassifying Employees and Independent Contractors

In recent years, there have been several high profile lawsuits related to employee misclassification, so don’t think it can’t happen to you. Review your relationship with each worker as well as your behavioral and financial control of each worker to ensure you’re classifying them correctly.

If you’re still not sure how to classify your workers, use IRS Form SS-8 Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.