Hiring: Employee or Independent Contractor?

I often speak with business owners who are ready to hire workers.  While this is a big step for a small business, many owners believe they can avoid paying employment taxes simply by calling these workers independent contractors.  I hate to be the bearer of bad news, but calling them independent contractors does not necessarily make them independent contractors.  This issue is particularly important now, because the IRS is cracking down on companies who aren’t paying taxes on workers that are actually employees.

How do you determine whether your worker is an independent contractor or an employee?  One word: control.  If the employer has it, the worker is an employee.  If the employer doesn’t, the worker is more likely an independent contractor.  The IRS considers three aspects of the employer/worker relationship when distinguishing between an employee and an independent contractor.

1) Behavior.  The more an employer controls the behavior of the worker, the more likely that worker is an employee.  Put another way, if the employer controls the manner and the means by which a worker completes his or her job, the worker is probably an employee.  A good example of this is a plumber.  If a home builder hires a plumber to install a kitchen sink, the home builder isn’t going to dictate what tools the plumber will use or the steps the plumber will follow to complete the installation.  The plumber is, therefore, an independent contractor.  If, on the other hand, the home builder hires a plumber and gives him a work truck, a tool box, a uniform, and dictates the steps by which the sink will be installed, the plumber is more likely an employee.  (As an aside, back in October, FedEx was accused of misclassifying thousands of workers as independent contractors.  The IRS found in favor of FedEx but has vowed to review some 6,000 companies to ensure they are properly classifying their workers.  Unless you have a war chest the size of FedEx’s, be sure your workers are properly classified.  For more info, see this BusinessWeek article from 11/5/09.)

2)  Financial.  If the employer controls the worker’s payments, particularly if they withhold taxes or reimburse expenses, the worker is more likely an employee.  Independent contractors are more often paid on an hourly or daily basis and are themselves responsible for their own taxes.

3)  Type of Relationship.  If the business will need the worker on an ongoing basis, or if the job the worker does is fundamental to the operation of the business, that worker is probably an employee.  However, where the worker is involved only temporarily, maybe to complete a particular project, that worker is probably an independent contractor.

As you can see, there isn’t a clear rule to follow.  I would encourage you to err on the side of caution and pay the taxes rather than risk being audited and then be responsible for back taxes, penalties and interest.  If you want the IRS to make the determination for you, you can submit the SS-8 Form “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.”

For additional information straight from the horse’s mouth, visit the IRS site specific to this issue.  And of course, consult an attorney before you hire…more on employment contracts later.

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