Defining and on-boarding employees correctly is essential to any business. But for some, distinguishing between employee and independent contractor becomes fuzzy.
An employee is a person who performs a service, with the employer controlling the methods and the results of the work done. Employers must withhold income, Social Security, and Medicare taxes from each employee’s paycheck. They also must match Social Security and Medicare taxes from their employer wages. Independent contractors must pay 100% of their tax liability. Contractors, however, maintain the control of how and where their work will be done.
Despite having clear cut definitions, employers frequently misclassify employees as independent contractors, whether by earnest mistake or in an attempt to bypass paying withholding taxes. This type of misclassification of workers has led to substantial losses for in revenue for the federal government. Because of this, the Internal Revenue Services is ramping up their efforts to identify cases of misclassification. To avoid a run in with the IRS, here are tests payroll and human resource departments use to determine employee status.
Common Law Test
Employers can determine most workers’ classification under the 'common law test.' The IRS itself uses this test to classify its workers. Under the common law test, control of what work will be done and how it will be done is key. If an employer has this control, then that person being tested is a common law employee. The employee-employer relationship is solid if this determination is made. If an individual has control of the results, but not the details, that person would not qualify as an employee. It is important to note it does not matter what an employer calls his or her workers - they could be 'agents' but still regarded as employees in law.
The aforementioned control of work and how work will be done can be split into three categories: financial, behavioral, and the type of relationship between the two.
If a business controls the right to direct finances, the worker is an employee. The following instances putting that control in the hands of the worker would qualify him or her as an independent contractor:
- Whether the worker has unreimbursed business expenses. This matters if they are an ongoing issue.
- Whether the worker has a substantial investment in work. Independent contractors, not employees, generally have financial investment in the places where he or she perform tasks.
- Whether the worker's’ services are available to the public. Employees of one employer do not solicit their work to the public at large, while independent contractors can and often, do.
- How the worker is paid. Employees are paid on a weekly, bi-weekly, semi-monthly, or monthly schedule. Independent contractors are paid by the job.
- Whether the worker can earn or lose a profit. Employees cannot do either.
These include factors that determine who has power to direct and control details by which and where the worker performs his or her tasks. Indicators include:
- Level of instructions an employer gives to a worker. If a worker receives detail instructions about when, where, and how to perform his or her job, that worker is an employee.
- Training provided to the worker. If a worker receives any type of training to aid in performing his or her job, that worker is an employee.
Type of Relationship Between the Two
How an employee and employer interact versus how an independent contractor interact and employer interact is very different. Here are some clues:
- Whether a written agreement exists. Independent contractors utilize these.
- Whether employee-type benefits (healthcare, dental) are provided. Only employees receive these.
- The length of the relationship. If a person is hired with the notion he or she will work indefinitely, that person is an employee.
- Whether the services provided are an important aspect of the business’s regular operations. This is indicative of an employee.
Reasonable Basis Test
Even if a worker meets the criteria of an employee under the common law test, he or she may be still considered an independent contractor and exempt from federal withholding if the employer has 'reasonable basis' to do so. Here’s what qualifies as a reasonable basis to not withhold federal withholding from a worker’s paycheck:
- Any IRS ruling or technical advice or court decisions sent to an employer indicating that the worker is an employee.
- A past IRS audit of the employer that did not result in a penalty attributable to the employer’s treatment of a worker as an independent contractor.
- A long withstanding, consistent practice in a significant segment of the employers’ industry of treating workers in similar situations as independent contractors.
- Advice from a business lawyer or accountant familiar with the business or similar reasonable advice.
Becoming familiar with these tests can aid employers when determining if a new hire is an employee or independent contractor, and subsequently help lower the amount of misclassified workers currently performing services.
Have you determined your employee's status and need help with proper withholding forms? Learn the best way to do it.