According to a study by Intuit Inc., by 2020 40% of American workers will be independent contractors. This employment trend is what is known as the gig economy. This free market system is a significant departure from traditional work arrangements. When employers leverage independent contractors, they save on the cost of benefits, office space, taxes, and employee perks. Conversely, workers can offer their services from wherever they want; they have the flexibility to determine their work schedule and the duties they will perform and can take advantage of tax breaks like the home office exemption.
While it certainly has its perks, this new landscape also poses unique challenges. Many business owners fail to recognize the effects of misclassifying an individual as an employee vs. independent contractor. Overlooking this critical designation exposes organizations to significant tax liabilities.
The Internal Revenue Service (IRS) defines an employee as anyone who performs services as directed and controlled by the employer. Classifying workers as employees requires that a company withholds applicable federal, state, and local income taxes; pays Social Security, Medicare taxes and state unemployment insurance tax; and pays worker compensation fees.
When a business hires an employee, they are required to file a number of returns with various taxing authorities and provide W-2s to all employees by January 31. Not to mention, employees may also have rights to benefits such as vacation, holidays, health insurance or retirement plans.
Over the years, we have encountered the following misinterpretations which lead to misclassifying an employee as an independent contractor:
“The worker wants to be treated as an independent contractor.”
“The organization is under contract with a service provider.”
“The worker does assignments sporadically, inconsistently or is on-call to the organization.”
“The worker is virtual.”
The determination of whether a worker is an employee or an independent contractor rests primarily upon the extent that the employer has to direct and control the individual regarding what and how to accomplish an activity.
- An employer controls how an employee performs a service.
- An independent contractor determines for themselves how to best complete a given assignment.
To help business owners avoid making classification errors, the IRS developed tests to help business owners determine the extent and direction of control present in any employer/employee/independent contractor situation. The degree of importance of each factor varies depending on the occupation and the facts of the particular case.
IRS Control Test
Behavioral Control
When the business can direct and control the work performed by the worker, the worker status is determined to be Employee. Consider:
- Is the individual required to comply with instructions about when, where, and how to perform the work?
- Have you trained individuals to complete a job using a particular method?
- Do you evaluate or direct how a worker performs their job?
When the person hired can work independently of direct instruction and oversight, the worker status is more likely Independent Contractor. Consider:
- Do you provide little guidance and exert minor control over the work performed?
- Independent contractors bring their skills to your enterprise – no training required.
- When evaluating work, do you focus on results instead of performance? This practice can point to either an independent contractor or an employee but in combination with the above test points toward the contractor designation.
Financial Control
If the business can direct or control the financial and business aspects of the worker’s job, it may suggest Employee status. Consider:
- An employer generally pays expenses, which means it has a right to regulate and direct business activities thereby indicating employee status.
- Usually, you will not see employees regularly market their services to the public.
- Paying your service provider by the hour, week or month suggests an employee status.
When a worker has a significant investment in his or her work facilities, this implies an Independent Contractor status. Consider:
- Independent contractors realize a profit or incur a loss.
- Paying an agreed-upon lump sum for a job suggests independent contractor status.
It’s important to note that in some situations, employers may implement a straight commission basis of compensation without adversely affecting a worker’s status as an independent contractor.
Relationship.
The type of relationship is dependent upon how the worker and business perceive their interaction with one another. Consider:
- Is there a written contract which describes the relationship the parties intend to create? A contract stating the worker is an employee (or an independent contractor) is not enough to confirm the worker’s status.
- Businesses often provide employees with benefits such as insurance, pension plan, vacation pay or sick pay. Employers rarely offer these benefits to independent contractors.
- Employees expect the relationship with their employer will continue indefinitely. Independent Contractors work for a specific project or defined period.
- If services rendered are a vital activity of the business and if the worker is an essential component of the regular business of the company, it suggests employee status.
If you need further assistance identifying whether your workers are independent contractors or employees, please give the professionals in our office a call today.