Independent Contractor or Employee?

The idea of hiring individuals to perform certain jobs without having to put them on the payroll is appealing to many business owners. But before you decide to use an independent contractor, make sure the person you hire is a genuine freelancer who is not needed to perform services integral to the operation of your company. Otherwise, the government could determine retroactively that the worker is actually an employee of your company—a change in classification that can result in severe financial and legal consequences for your business.

While companies outsource jobs to independent contractors for a variety of reasons, a primary motivation is often to save money. For employees, companies are obligated to withhold federal, state, and Social Security (FICA) taxes, and to pay unemployment and workers’ compensation insurance. Many employers also provide a range of voluntary benefits to employees, such as health insurance, retirement plans, and vacation and sick leave. Because these taxes and benefits can add to the cost of hiring an employee, the temptation is great for a company to instead classify a worker as an independent contractor.

Classification Rules

You should be aware, however, that the Internal Revenue Service (IRS) and other federal agencies apply a set of common-law rules to differentiate an employee from an independent contractor. While a worker must not meet all of the government’s criteria to be considered an independent contractor, the onus is on the hiring firm when questions are raised to demonstrate that the contractors it hires are in business for themselves and are not employees-in-disguise.

The IRS has established as a general rule that the hiring firm has the right to control or direct only the result of the work performed by an independent contractor, but not the means and methods of accomplishing the job. Independent contractors may not be given extensive instructions by the hiring firm about what hours they should keep, where they should perform the work, what tools or equipment they should use, whom they may hire as assistants, or from whom they may buy supplies or services.

Businesses are also not permitted to issue detailed instructions to independent contractors on how to perform the assigned work. Because the rules specify that independent contractors should not be responsible for jobs that are integral to the business’s day-to-day operations, contractors do not usually receive training in company policies and procedures. Indeed, an independent contractor more typically provides specialized services that are not otherwise performed within a company, such as IT support or legal advisory services.

Another defining characteristic of an independent contractor is financial autonomy. When considering whether a worker or service provider may be properly classified as an independent contractor, the IRS views favorably evidence that the contractor has a significant investment in his or her own tools and equipment, charges flat fees, covers his or her own business expenses, and has the opportunity to make both profits and losses. Independent contractors often work for a number of clients simultaneously and may publicly advertise their services.

A worker who relies substantially on the income provided by a single a client is less likely to pass muster as an independent contractor. An individual is typically considered to be an employee if he or she works full time for the hiring firm, is engaged for an indefinite period of time rather than for a specific time frame or project, receives hourly pay (with the exception of law and certain other professions), works on the firm’s premises, collects employee benefits, and is entitled to quit without incurring liability for breach of contract.

If you are uncertain about how to classify a worker for tax and legal purposes, you have the option of completing IRS Form S-88, “Determination of Worker Status for Purposes of Federal Employment Tax and Income Tax Withholding.” The form, which may be completed by either the firm or the worker, includes a comprehensive list of questions intended to establish the nature of the relationship between the hiring company and the service provider. An IRS technician will review the form and render a decision.

Often companies do not fill out S-88 until forced to do so because they are being audited or a complaint against them has been filed. If the IRS determines that a worker you have classified as an independent contractor is actually an employee, your firm will be required to pay back taxes, as well as a penalty. A failure to classify workers properly can also lead to charges of labor law violations. For specific guidance, consult your tax professional.

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