The IRS helps employers determine employees versus independent contractors based on three areas:
The relationship between parties
Before we dive into these categories, let’s first talk about why this matters.
Whether you are a business, employee, or contractor, it is important to understand the difference. Depending on how your work is classified will determine the number of rights you have and how you are taxed.
It can be more expensive for a company to hire an employee over an independent contractor due to income taxes, social security, medicare taxes, and unemployment taxes. So sometimes it can be tempting to smear the lines a bit and classify someone as an independent contractor when they should be an employee.
This can be unfair to the contractors who are now losing the benefits associated with contract work, simultaneously they will be required to pay more in taxes.
Some states have even been cracking down on business owners. California, for example, has been imposing fees on those who do not comply.
Let’s now look at the two classifications and what aspects should be present in the job of the individual.
The employer has the right to instruct how the employee should conduct business and make adjustments to their performance. This differs from contract work where the employer is likely hiring a contractor who has obtained a certain skill level that does not require close management oversight by the employer.
Employee Behavioral Aspects Include:
Employer influences when and where the employee can work. Such as office location, meeting times, and hours of operation.
There is a higher level of instruction, which may involve training, mentoring, or more detailed requirements of the work.
Employers regularly encourage and provide training to employees on how to improve their skills or work within the organization more efficiently.
The employer may make requests to meet at certain places, offer resources to make the job easier, or request changes to the work provided, but it is the nature of the relationship that is most important. Contractors should be seen as equals and in a B2B relationship.
The business has a right to instruct the business expenses and income of the employee’s job. When an employer pays an employee, it is not expected that a paycheck is directly needed to complete their job. Whereas contractors cover their own expenses, including operating and administrative.
Employee Financial Aspects Include:
Employees are more likely to be reimbursed for their expenses.
The employee does not carry the risk of losing personal assets based on their work.
Generally, employees are not free or able to easily seek outside work from other employers.
Contractors also carry more of a weight of liability. This differs from employees who may be more protected by the business they work under.
These aspects of the relationship define the acceptable interactions between the employee and employer. This can be based on a number of factors, but the essence is the employee is under the direct direction of their employer, whereas the contractor has more flexibility in how they conduct business on their end.
Employee Relationship Aspects Include:
Often, employees are subject to some benefits like vacation pay, sick pay, or health insurance.
The term of the agreement with an employee is usually considered indefinite until one party terminates the agreement.
Employees are often seen as integral parts in keeping the business running.
The employer has limited authority on controlling how the independent contractor conducts their business. While the employer can have an influence on how the contractor does their work, ultimately it is up to the contractor.
Independent Contractor Behavioral Aspects Include:
The employer does not influence when or where the independent contractor does their work. For example, the contractor can stipulate they only work within a certain range of hours and conduct their work at home or office of their choosing.
The employer offers limited instruction and the independent contractor has more influence over how the job can be done.
Independent contractors participate in training on their terms and by their methods.
The business does not have the right to instruct the business expenses and income of the contractor’s job. A contractor will likely need to cover the expenses that are necessary to do their job, which is the expectation of the employer. For example, if a contractor is hired as a writer then it is their responsibility to obtain a computer or whatever materials are needed to complete the work.
Independent Contractor Financial Aspects Include:
It is uncommon for independent contractors to be reimbursed for their expenses.
Independent contractors carry the risk of profit or loss when performing work for the employer.
Independent contractors have the freedom, and generally, the capabilities, to seek out work from other employers.
Contractors should consider this distinction when pricing their services. Contractors should not only consider their labor, but also tax expenses and any administrative or operating costs that will be necessary to complete the work.
These aspects of the relationship define the acceptable interactions between the contractor and the employer. There is no distinct checklist for determining the relationship aspect between an employee and an independent contractor, rather it is the overall essence of how the two operate.
Independent Contractor Relationship Aspects Include:
Generally, benefits like vacation, sick pay, or pension plans are not offered to independent contractors.
Independent contractors likely have an agreement made up that determines how long a contractor will be employed, either determined by time or project-based.
Independent contractors rarely perform key services that are part of keeping the business running.
Expanding your business is an exciting time, but it is important you properly classify each new worker that helps your organization grow. So when your payroll grows or you need to file an additional 1099-NEC be sure to contact your ProAdvisor to make sure you are in compliance.
This publication is designed to provide information on federal tax and accounting laws and/or regulations. It is presented with the understanding that the author is not rendering legal or accounting services.
This text is not intended to address every situation that arises or provide specific, strategic tax and/or accounting planning advice. This text should not be used solely to answer tax and/or accounting questions and you should consult additional sources of information, as needed, to determine the solution to tax and/or accounting questions.
This text has been prepared with due diligence. However, the possibility of mechanical or human error does exist and the author accepts no responsibility or liability regarding this material and its use. This text is not intended or written by the practitioner to be used and cannot be used by a taxpayer or tax return preparer, for the purpose of avoiding penalties that may be imposed.