Employees vs. Independent Contractors Deep Dive

As a CPA I get asked about this distinction at least 2 times a month. It is a very important and sensitive topic for growing businesses and the individuals who work for them. 

It is also complicated, and deserves spending some time to understand if you are a small business owner.

When you look at how to classify a worker, what you are most likely thinking is: 

“How do I make this person an Independent Contractor or (IC)?” 

Using IC's is much easier than setting up employees, in most cases is less expensive, and IC's do not come with the additional overhead issues of employees.

So why not just make everyone an IC? Because on the other side of this argument is employment law and the IRS (along with state agencies). 

The IRS takes employment taxes just as seriously as income taxes. In fact, I believe they care much more about employment taxes because they are so complicated and fraught with wrong doing.

The IRS also knows that if everyone was an IC, their collections on Social Security Tax, Medicare Tax, Unemployment, etc. would diminish considerably. 

So in order to protect the systems of those services and taxes, it is best thing start by thinking the IRS wants you to make EVERYONE an employee....

The Differences

Before we get into how to determine if you make a new worker and IC or an Employee, lets discuss exactly what the differences of the two are:

Independent Contractor

Usually an individual or a company

Requires an I-9 to be kept in your file

Must maintain their own workers compensation insurance

No payroll taxes paid or withheld

No unemployment insurance paid

Compensation in form of direct payment

Does not participate in company benefits

Does not participate in company health care

Employee

Always an individual, a company cannot be an employee

Requires a W-4 to be completed along with state paperwork and usually a job application

Covered under your workers comp insurance

Must have Federal and State Withholding

Must have FICA withheld

Must have unemployment tax paid on behalf

Compensation in form of payroll net checks/direct deposit (usually requires payroll system or software).

Participates in company benefits and health care (when qualified)

As you can see, from an employer perspective, using the IC in relation to cost is quite advantageous. 

I know that many would say there are drawbacks to the IC too. Some might say they do not participate in the culture the same way. That they feel less of a part in the company.

That all may be true, but for this discussion I am sticking to the financial factors. A great blog on the emotional and productivity factors can be found here.

So if we have proven that IC's are less expensive than employees, then the next question should be: “What is the test for classifying someone as an IC INSTEAD of an employee?”.

It is a good question, and one with no perfect answer. But let me give you the advice I give my clients.

Classification Tests

The first rule that I personally use to determine status of a worker is: “How many hours will the worker perform tasks for your business vs other businesses?”

In most cases this gets down to the heart of the issue in that if someone works for you and only you, for several months or years, then there is a very high likelihood they are an employee.

There are cases where vendors may work for you full time for weeks or months, so that does not qualify. But the longer the time frame, the more likely they are employees if you are their only job.

The IRS focuses on 3 factors called their “Common Law Rules”:

Behavioral Control- Does the company control or have the right to control what the worker does and how the worker does his/her job?

Financial Control- Does the company control the business aspects of the workers job. This can be how they are paid, expense reimbursement, what tools and supplies they use, etc.

Type of Relationship- Are there any contracts between the worker and the company, are any benefits paid, is the relationship temporary or permanent?

These are all somewhat vague tests, so having a set of circumstances that your company adheres to is best. 

While not perfect, here are the guidelines I give my clients:

1. The first rule above- How many hours working for you vs other business?

2. Do you have a consulting agreement or contract of any kind?

3. What equipment will they use, do they bring their own computer, do they use their own vehicle?

4. Do you instruct them how to do their job, or do they know how to do everything and you just let them work on       their own?

5. Are they paid weekly or bi-weekly? Most contractors are paid immediately when a job is done, or monthly.          Showing regular pay period with regular amounts leands toward employee.     

If you can answer most of those questions in a way that shows the worker to be an IC, then you should take advantage and feel confident in it.

There are also some classifications where IC is easier. If you are employing professionals like doctors, lawyers, accountants, vets, auctioneers, etc. they are usually IC's.

Conclusion

So what would I do if I were trying to setup a business that legitimately had only IC's?

First I would not employ anyone 40 hours a week. Doing so almost always means that if that is the case long term, they are employees.

Second, I would ask anyone who did want to work for me to open a corporation and that I would create a contract with their corporation for what I need done. That the expectation is they bring their own laptops, tools, vehicles, etc.

Third, I would pay them randomly as tasks are completed. Sometimes I would pay immediately, sometimes I would pay 30 days later. I would always cut a check to them and mail it.

Finally, I would encourage them to work for others as well, I still believe that is the strongest defense.

Obviously most businesses would be tough to run this way. And rightly so, employment is a vital part of our economy, but if you can see a way to run it with some or all IC's, then there are clearly financial advantages to doing so...