What’s The Difference Between An Employee And An Independent Contractor?

One of the hottest topics at the Internal Revenue Service these days is the misclassification of employees as independent contractors by businesses. The financial consequences to the business owner for misclassification can be substantial, in the form of back taxes, interest and penalties. The following is an overview of the issue, the background and some practical tips to avoid the costly outcome of misclassification.

It can be advantageous for a business to pay independent contractors instead of hiring an employee. An independent contractor does not have to be included in the business’ health insurance plan, retirement plan, workers’ compensation policy, union benefits, Social Security and Medicare match, unemployment insurance, record-keeping, etc. These avoided costs can be significant savings to the business. There is nothing wrong or illegal or tax evasive for a business to engage with an independent contractor as long as the contractor is not a misclassified employee in accordance with the rules and regulations of the IRS, Department of Labor, State Departments of Revenue, etc.

So, how do you determine if this person you are about to hire is an independent contractor or an employee?

The IRS has established 20 factors to be used to distinguish an employee from an independent contractor. These 20 factors can be categorized into 3 criteria:

1. Behavior control

2. Financial control

3. Relationship of the parties.

Here are a few examples of the 20 factors: training, supervision, set hours of work, reimbursement of expenses, furnishing of tools and materials, realization of profit or loss, working for more than one business at a time and right to terminate. The complete list can be found on our website, www.baseballaccountants.com. As the IRS auditor reviews that facts and circumstances to determine if the relationship is an employee or independent contractor, and the outcome is subjective. Each case is different and each of the 20 factors has more or less relevance or weight in each case. Obviously, the IRS or the Department of Labor or the states’ Department of Revenue or Labor are strongly motivated to classify the relationship as an employee to collect taxes and protect the workers’ rights to benefits.

There are certain actions that can be taken to support your position that the relationship is with an independent contractor.

You can give instruction and guidance as to how your business would like the job or task completed, but you should avoid mandating how the job is to be done or providing training manuals. The independent contractor and the business should have a well-drafted contract evidencing the independent contractor relationship. The worker should be in control of his or her own work schedule. Also, this person should supply their own tools and materials, if possible.

It’s also very beneficial if the worker has many customers or clients and is not substantially dependent on your relationship for their source of income. The independent contractor should submit invoices to the business on their own letterhead. Like any independent business, the independent contractor should be responsible for their own expenses, helpers, and not be guaranteed any profit from the job. Again, the facts and circumstances of each situation are unique and not all of the 20 factors may be relevant.

The IRS can impose substantial interest and penalties in addition to the unpaid federal withholding taxes, unpaid Social Security taxes and unpaid Medicare taxes if an independent contractor is reclassified as an employee. The law allows the IRS to impose penalty rates on these unpaid taxes which are higher than the withholding rates if the employees were properly classified originally. After the unpaid taxes are computed, a failure to file penalty and a late payment penalty are assessed at 25 percent and 10 percent, respectively. The respective state Department of Revenue can assess back taxes, interest and penalties, in addition to the IRS. The cost of misclassification can be substantial.

This article is not intended to be all-inclusive as it relates to this very complex issue. There are many other aspects of this issue that haven’t been addressed in this article, such as statutory employees, statutory independent contractors, and safe harbor rules. Like most business issues, the answer is not black or white. We strongly encourage you to consult your professional advisors if you think that your situation is not clear and could be interpreted differently by your business and a taxing authority.