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When is an independent contractor an employee?

From a cost perspective, employers would be happy if every worker could be treated as an independent contractor. That's because independent contractors aren't subject to fair labor standards, health and safety protections, or unemployment and workers' compensation benefits. They don't require as much paper work and they fall under fewer regulations. In addition, independent contractors pay their own payroll taxes, fund their own retirement plans, and pay for their health insurance. The administrative and tax savings for an employer can be huge.

Unfortunately, what's good for the employer can be bad for the employee and bad for the IRS and other agencies. The IRS (and state tax authorities) would prefer to have all workers treated as employees who have their payroll and income taxes withheld from their paychecks. When taxes are paid through withholding, the IRS has an improved cash situation. The Department of Labor would also like to see all workers classified as employees who are protected by fair labor standards, health and safety rules, and unemployment protection to workers.

Pressure to reduce costs
Guess what happens when the economy tightens and employers look for ways to reduce their costs? Employers reduce costs by replacing employees with temporary "independent contractors" who aren't subject to employer taxes and benefits.

Big brother is watching
The IRS and the Department of Labor have therefore teamed up to review these situations in pursuit of "employee misclassification." The determining factors are not particularly clear, leaving the IRS lots of room to make their case.  

Here is the guidance provided by the IRS in this area:

"In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.

Facts that provide evidence of the degree of control and independence fall into three categories:

  1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
  2. Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
  3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?"

Here are some of the behavioral factors that may be considered:

  • Type of instructions given
  • Degree of instruction
  • Evaluation systems
  • Training

 Independent contractors normally have financial control evidenced by:

  • Significant investment in their tools or equipment
  • Unreimbursed expenses
  • Opportunity for profit or loss
  • Services available to the market
  • Method of payment

 The type of relationship can also influence the worker's status:

  • Written contracts
  • Employee benefits
  • Permanency of the relationship
  • Services provided as key activity of the business

Treat employees as employees
From our experience, it is very difficult to classify most workers as independent contractors. We encourage you to look elsewhere for cost savings and to contact us if you have specific questions about worker classification.