Sooner or later, most business owners need to hire people to help them. Whenever you hire someone, you need to decide whether the person is your employee or an independent contractor (“IC”). This question of work status is a surprisingly big deal.
Why is this a big deal?
Employees and independent contractors get treated very differently for tax and other legal purposes. As a rule, ICs cost you less than employees.
When you classify a worker as an employee, you become an unpaid tax collector for the government. You have to do all these things:
- Withhold income, Social Security, and Medicare taxes from the employee’s pay and pay them to the IRS
- Pay half the employee’s Social Security and Medicare taxes out of your pocket—this is a 7.65% tax up to an annual income ceiling
- Comply with your state’s minimum wage laws
- Provide the employee with unemployment insurance coverage
- Cover the employee with worker’s compensation insurance coverage
- Pay the employee time-and-a-half for overtime, unless overtime pay rules do not cover them
- Adhere to other federal and state labor laws—for example, guaranteeing employees’ the right to unionize
- Provide the employee with workspace and equipment
- Offer a minimal amount of paid sick leave in most states
- in some states, provide the employee with family medical leave
Employers also typically provide employees with some sort of health insurance. Health coverage is required for employers with more than 50 full-time employees. Other benefits, like paid vacation, are also usually provided.
When you classify a worker as an IC, you don’t have to do any of these things. You just have to pay IC money for the work performed.
As a result, it is usually cheaper to classify a worker as an IC than an employee. It is often as much as 30% to 40% cheaper.
You might be thinking: “Great, I’ll classify every worker I hire as an IC.” Unfortunately, it’s not so simple.
Who decides worker status
Initially, it’s up to you to decide whether to classify a worker you hire as an employee or IC. You don’t need to ask anyone for advance permission when you designate a worker as an IC.
However, your worker classification decisions are subject to review by many different government agencies. These include:
- The IRS
- Your state income tax department (in the 43 states with income taxes)
- Your state unemployment compensation insurance agency
- Your state workers’ compensation insurance agency
- The United States Department of Labor, and
- Your state labor department.
These agencies prefer that workers get classified as employees, not ICs. That way, it’s harder to evade taxes. And more money gets paid into the state unemployment insurance and workers’ compensation system.
The dangers of worker misclassification
What happens if one of these agencies determines that you misclassified workers as ICs instead of employees? Answer: Many things, all of them bad.
You may have to pay substantial fines and penalties—and we’re not talking parking ticket type fines. Companies have gone out of business due to the IRS penalties for worker misclassification.
In addition, workers themselves can sue you if they claim you misclassified them as ICs.
The bottom line: Do not classify any worker as an IC simply because it’s cheaper. The worker must truly be an independent contractor.
Who is an independent contractor?
A worker is not an IC simply because you say so—even if you and the worker sign an agreement saying so.
So, how can you tell if you should classify a worker as an IC?
Here’s the basic rule: ICs are in business for themselves. Employees work for someone else’s company.
Often, it’s perfectly evident that a person is in business, and is an IC. In many other cases, however, the issue is not so clear.
Courts and agencies have developed various legal tests to determine how to classify workers. Unfortunately, the tests can be confusing and hard to apply.
The right of control test
The main test used to classify workers is the right of control test. It’s also called the common law test.
The IRS uses this test, as do most state tax departments. It’s also used in many states for worker’s compensation and unemployment insurance purposes.
Here’s how the right of control test works:
Workers are employees under the test if the people for whom they work have the right to direct and control the way they do their jobs. This right of control extends to both the final results and the details of when, where, and how the work gets done.
In contrast, when you hire an IC, you hire an independent businessperson. You do not have the right to control the way an independent businessperson—an IC—performs agreed-upon services. The only control you have over an IC accepting or rejecting the final results the IC achieves.
The IRS looks at three areas to determine whether a hiring firm has the right to control a worker. These are:
- Behavioral control on the job
- Financial control, and
- The firm’s relationship with the worker
Here a chart from the IRS that shows how it analyzes these factors:
A worker is more likely an IC if:A worker is more likely an employee if:Behavioral control Factors that show whether a hiring firm has the right to control how a worker performs the specific tasks he or she has been hired to do
- You do not provide training
- You do not give the worker instructions how to do the work
- You do not evaluate how the worker performs
- You provide instructions that the worker must follow
- You give the worker detailed training
- You evaluate how the worker does the job
Financial control Factors showing whether a hiring firm has a right to control a worker’s financial life
- The worker has a significant investment in equipment and facilities
- The worker pays his or her own business and travel expenses
- He or she provides a service available to the public
- He or she get paid by the job
- He or she has opportunity for profit or loss
- You provide equipment and facilities free of charge
- ou reimburse the worker’s businss and travel expenses
- The worker makes no effort to market his or her services to the public
- You pay him or her by the hour or other unit of time
- He or she has no opportunity for profit or loss—because you pay by the hour and reimburse all expenses
Relationship between worker and firm Factors showing whether a hiring firm has a right to control a worker’s financial life
- You don’t provide employee benefits such as health insurance
- You sign an IC agreement with the worker
- The worker performs services that are not a part of your regular business activities
- You provide employee benefits
- You have no written IC agreement
- The worker performs services that are part of your core business
No one factor is determinative by itself. And there is no magical number of factors that must point to IC status for a worker to be an independent contractor.
Tips for using independent contractors
Here are three tips that will help you stay out of trouble when you use ICs.
1. Use written independent contractor agreements
A written agreement describing the worker as an IC is good evidence that you and the worker intended to create an IC relationship. A written IC agreement, by itself, can never make a worker an IC, but it can be helpful in close cases.
2. Treat the worker like an IC, not an employee
Be sure to treat the worker like an independent businessperson, not an employee. For example:
- Don’t supervise the IC or his or her assistants
- Don’t let the IC work at your offices unless the nature of the services absolutely requires it
- Don’t establish the IC’s working hours
- Don’t provide ongoing instructions or training
- Don’t provide equipment or materials unless necessary
- Don’t pay the IC’s travel or other business expenses. Pay the IC enough to cover these expenses out of his or her own pocket.
- Don’t give an IC benefits such as health insurance
- Don’t pay ICs like you pay employees. Instead, require all ICs to submit invoices. Pay the invoices at the same time you pay other outside vendors.
3. File all required 1099-NEC forms
If you pay an IC $600 or more during the year, you must file a form with the IRS to report the payments. This reporting is critical. Failure to do so will result in severe penalties if the IRS later audits you and determines you misclassified the worker.
Until 2020, you had to file IRS Form 1099-MISC to report payments to ICs. Starting in 2021, you must submit the new IRS Form 1099-NEC. Start using it in 2021 to report payments made to ICs in 2020. The form is due January 31, 2021, to report 2020 payments.
