When you hire people to work for you, it’s important to consider employee vs contractor guidelines and tax compliance issues like the question of whether someone who works for you is an employee or a contractor. This means determining if the worker is self-employed or employed by you. If handled incorrectly, there can be penalties for you as a business owner, as well as for your worker.
Thankfully, there is specific guidance from the Internal Revenue Service (IRS) about employee vs contractor you can follow when making this classification, but it is still your responsibility as a business owner to understand the difference and classify your worker appropriately based on the applicable tax rules for the classification you determine.
What’s the big deal?
Employee vs contractor is treated differently for tax purposes by the IRS. There is specific guidance from the IRS provided in more detail below, but here’s why the difference is important.
The main concern is a person’s eligibility for employee benefits like Social Security and Medicare taxes. Difference Between employee vs contractor, it’s up to them to contribute to these benefits. If however, the person is an employee, it’s up to you, as the employer, to make sure these benefits are paid on the employee’s behalf.
Payroll benefits are expensive, and some businesses try to game the system by classifying all their workers as contractors and, therefore, not having to pay payroll benefits. The problem with this way of thinking is it goes against what the IRS states, and this can result in large penalties and interest for the business. It can also result in non-existent coverage when the employee needs it.
What the IRS Says
To keep your business onside, you must follow the employee vs contractor guidelines set out by the IRS to answer the employee vs contractor question. The IRS provides three categories for consideration when determining if your worker is an employee or a contractor. These categories are the working relationship, financial control, and behavioral control.
When the IRS considers whether a worker is an employee or a contractor, they look at how the worker and the business describe their relationship. Does the worker consider themselves an employee?
Without the existence of a well-written contract, and sometimes even when one exists, it can still be difficult to prove the nature of the relationship. Because of this, there are a number of additional criteria the IRS looks at.
Key relationship items in employee vs contractor or determining whether a worker is an independent contractor or an employee include whether the worker is receiving benefits only employees can receive, whether the relationship is considered permanent, and whether the services performed by the worker are considered essential activities of the business.
Financial control is the right to direct the financial and business aspects of the worker’s job. With regards to financial control, consider who is the most invested in the relationship. Who is taking on the financial risk or the ability to profit?
When looking at financial risk, your worker is an employee if they aren’t responsible for paying operating costs, they aren’t financially liable if the contract isn’t fulfilled, they have no say over how much and when you pay them, and they have a continuous relationship with you.
With regards to financial risk, your worker is a contractor if they are hired for a specific job rather than continuously, they can hire help, they could be held financially liable if the contract is not fulfilled, they don’t receive any payroll benefits from you, and they actively market their services.
Part of financial control is the ability to profit from the work. When considering the opportunity for profit, your worker is an employee if they don’t have the ability to realize a profit or loss from the work and they are entitled to benefit plans normally offered to employees such as group life insurance and extended health benefits.
Your worker is a contractor if they can hire someone to help them and they are compensated by a flat fee and incur their own expenses while completing their job.
A final consideration when it comes to financial control is the investment in tools and equipment. If you supply the tools and equipment as well as their maintenance and retain the right to use the tools and equipment, your worker is an employee.
If the worker provides their own tools and equipment and has made a significant investment in the tools and equipment they need to perform their work, they are a contractor. Often, the supply of their own workspace and its maintenance goes along with this shows the difference between employee vs contractor.
The key question when considering behavioral control is: How much control do you have over how and when the work gets done? This is easier to determine in some professions than others, especially those with flexible work arrangements.
With regards to behavioral control, your worker is likely an employee if you are the one who determines how and when the work is carried out, how and when the worker is paid, the jobs the worker will do, and the training the worker receives.
In contrast, your worker is likely an independent contractor if they work independently, set their own hours, decide the jobs they will do, set their own rates for the work, and are not expected to continue the relationship beyond completing the work.
The IRS will examine all these factors on a case-by-case basis when looking at the employee vs contractor question. They try to get a well-rounded picture of the situation before determining employment status. It’s important you consider all these factors as well.
Inevitably, there are always challenges when it comes to staying on track with IRS compliance. If you feel your situation doesn’t fit neatly into the examples above or you’ve possibly misclassified a worker and need further guidance, contact us to learn more about how these employee vs contractor rules apply to your unique situation.