So, your business is growing and you are ready to outsource or delegate some of the work. However, you are confused about how to classify a new team member: employee or independent contractor? The following is an overview of classification of workers to help guide this important business decision. As with any aspect of your business that is of a legal or tax nature, you should consider seeking the formal advice of an accountant and/or attorney to assist you. Hopefully, this overview will provide you with enough basic information to ask relevant questions of your business advisors.
Classification of Workers
- Classification of a person as an independent contractor or employee is important for tax purposes.
- For an independent contractor, you must file IRS Form 1099-MISC to report payments of $600 or more.
- If you classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker, which typically include income taxes, Social Security, Medicare, and unemployment.
- If you want the IRS to determine whether a worker is an independent contractor or an employee, you can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
Independent Contractor vs. Employee
- As a general rule, an individual is an independent contractor if the person for whom the services are performed has the right to control or direct only the result of the work, and not what will be done, how it will be done, or the method of accomplishing the result.
- An individual is an employee if he or she performs services for an employer and the employer can control what will be done and how it will be done.
Categories of Control
The IRS examines the relationship between the business and the worker by reviewing 3 categories:
- Behavioral Control
- Financial Control
- Type of Relationship
- These 3 areas form a list of 20 factors that the IRS uses to determine the distinction. IRS Revenue Ruling 87-41 outlines the 20 factors in detail.
- Generally speaking, independent contractors retain control over their schedule and number of hours worked, jobs accepted, and performance of their job.
- Employees usually work a schedule required by the employer and their performance is directly supervised.
- IRS Publication 1779, Independent Contractor or Employee, is another valuable resource that discusses the differences between the two classifications.
- Behavioral Control
Behavioral control covers whether the business has a right to direct or control how the work is done through instructions, training, or other means.
- When and where to do the work.
- What tools or equipment to use.
- What workers to hire or to assist with the work.
- Where to purchase supplies and services.
- What work must be performed by a specified individual.
- What order or sequence to follow.
- Whether worker is trained to perform services in particular manner.
Training is an area where some small businesses come close to creating an employment relationship with independent contractors by requiring detailed training, including “shadowing” of the business owner/service provider, and requirement that services be provided in a certain manner.
Requiring an independent contractor to have taken certain classes is not the equivalent of providing training, but merely requires a qualification level and skill set required for work. It may be a safer route to take when hiring subcontractors. Also, training in company policies is not necessarily the same as training in how to do the actual services.
2. Financial Control
Financial control considerations are as follows:
- The extent to which the worker has unreimbursed expenses.
- The extent of the worker’s investment in the facilities used in performing services.
- The extent to which the worker makes his or her services available to the relevant market.
- How the business pays the worker.
- The extent to which the worker can realize a profit or incur a loss.
3. Type of Relationship
The IRS examines the relationship between the parties:
- Written contracts describing the relationship the parties intend to create.
- The extent to which the worker is available to perform services for other, similar businesses.
- Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation or sick pay.
- The permanency of the relationship.
- The extent to which services performed by the worker are a key aspect of the regular business of the company.
For more detailed information visit www.IRS.gov and refer to IRS Publication 15-A, Employer’s Supplemental Tax Guide or IRS Publication 1779, Independent Contractor or Employee.
Terms of an Independent Contractor Agreement
The following are typical clauses found in an agreement between a retaining business and an independent contractor:
- Define independent contractor status
- Scope of work (duties & required responsibilities)
- A non-solicitation and/or non-compete clause
- Non-disclosure clause
- Consent to use of trademark
- Payment terms (compensation & out-of-pocket expenses)
- Term of project or relationship/termination
- Obligation to carry general liability insurance
- May also include a governing law provision, indemnification clause, conflict of interest clause, non-hire provision, and request for taxpayer ID number for 1099.
- Non-compete agreements are reviewed by the courts for reasonableness based on several factors, including the nature of the business, the nature of the worker’s duties, the geographic territory encompassed by the non-compete, and the length of time chosen. They are often hard to enforce.
- Non-solicitation agreements can protect against stealing of clients and/or employees.
For an employee, you can draft a basic employment letter outlining date of hire, salary and benefits package, probationary period, pay raise eligibility, etc. Employees are generally “at will” unless otherwise designated, meaning they can be discharged due to any legitimate, non-discriminatory basis.
The employer chooses which benefits to offer (sick leave, vacation, etc.); benefits are usually not required (check state and local laws and regulations). Benefits are mostly based on industry standards and employee expectations, and are used to entice employees.
As with any major business decision, do your homework — speak with expert advisors, (accountant, attorney, business coach, etc.), and speak with colleagues that have experience in retaining workers in order to find out which classification makes the most sense for your business.
© 2010 Lisa Montanaro. Information provided in this article is intended as a general overview and is not to be construed as the rendering of individual legal or tax advice.