One of the more difficult concepts to grasp for many employers and those new to the business world is the difference between an employee and an independent contractor. The differences between these roles can greatly affect the taxes of the worker and the liability/responsibility of the employer. For a better understanding of the difference between the two roles, I have outlined the factors that the IRS uses to determine which category a person falls under for tax purposes. This test can be used as a general guideline for employers, employees and independent contractors to ensure that they maintain their roles and understand their responsibilities both on the job and with the IRS.
The IRS has a list of 20 factors that it uses to determine whether or not a worker is an employee under the Tax Code. The three most important factors are:
- Instructions: requiring a worker to follow your instructions as they pertain to the work they are doing. This includes where they do the work, when they need to do the work/have it completed, and how to complete the job (either specific instructions or a set schedule of the different stages of work required).*minor instructions such as what hardware to use when installing your kitchen cabinets, is not enough instruction to create an employer-employee relationship*
- Training: Requiring work to be done in a specific manner by offering training that teaches the worker how to complete different tasks required by the position usually indicates an employer-employee relationship. Whether these trainings be weekly meetings, shadowing a senior worker or attending a mandatory training before becoming employed, these activities all give the employer control over how the worker should do their job and therefore indicate an employer-employee relationship.
- Profit/loss: An employee receives a salary to do the work they were hired to do day in and day out. They are susceptible to being fired, promoted or disciplined based on their job performance. An independent contractor has a financial stake in the work and if their work is not up-to-par, they may not get paid; if they take too long, they may not realize any profits, or even suffer a loss.
I have broken down the factors the IRS uses to differentiate between employee and independent contractor into 3 different categories: Employer responsibility – what the employer should control; Financial responsibility – who pays for what; and Miscellaneous – who makes the decisions that cannot be categorized.
Where the employer is responsible for a majority of the decision making, then an employer-employee relationship is probably set in place. The following decisions, when made by the worker, would create an independent contractor rather than employer-employee relationship:
- When, where and how the work is done;
- When, how and what training is required;
- Hiring, supervising and paying assistants/helpers;
- Determining work schedule;
- Requiring full-time work (40-hour weeks);
- Determining order/sequence of work;
- Deciding when to terminate work; and/or
- Requiring the worker to work at the office/company premises when work can be done elsewhere (from home or a satellite location).
While many employees pay for a lot of their employment expenses (gas, brief-case, toolbox etc.), there are certain expenses and financial decisions that, when left to an employer, create a different relationship than when they are the decisions of the worker. The following decisions/responsibilities, when made by the employer, create more of an employer-employee relationship:
- Pay schedules determined by hourly, weekly or monthly pay-rates. (commission payments would reflect more of an independent contractor status);
- Reimbursement of travel expenses or other business expenses associated with a job paid by the employer;
- Providing the required tools, equipment and materials at the job-site for workers to use to complete the job;
- Providing, maintaining and paying for a work facility, job site or office for the employee to work in;
- Realization and/or distribution of profits;
- Part of the business: When the work that the workers are employed to do is an inherent part of the business, typically, the workers are considered employees. Their work is directly related to the business, requiring them to do their work in a specific manner, repeatedly, each day.
- Personal services: While workers who are employees are assigned specific tasks and confined to their roles, independent contractors are able to expand their personal services to whichever area they like and offer different services to different jobs.
- On-going relationship: Typically, when a worker has a working relationship with one company, they are considered to be an employee. However, there have been many independent contractors who have multiple on-going contracts with the same business that could indicate an employer-employee relationship. One thing that may assist in differentiating the two is that an employee is contracted for their role, while an independent contractor may be contracted for a series of tasks.
- Status reports: While independent contractors typically provide updates on their projected schedules, the IRS looks to see if a worker regularly provides written/oral reports to determine their relationship. Daily, weekly, or monthly reports usually indicate an employer-employee relationship.
- Multiple Companies: When a worker has jobs/responsibilities to several different, unrelated companies at the same time, they are likely independent contractors. In addition, the independent contractor can decide who to offer their services to without requiring permission from the employer – they are available to the public.
- Ability to discharge workers: When there is an employer-employee relationship, the employer has the ability to discharge the employee at any point in time. In contract, an independent contractor usually works under a contract and cannot be discharged without liability to the employer if the discharge is not permitted under the contract.
While this list can seem rather intimidating, it is essentially what the SS-8 form found on the IRS website reflects. The application to determine “employee work status for purposes of federal employment taxes and income tax withholding” is used by many employers as a self-audit to make sure they are in fact acting as employers.
It is also important to understand that a worker need not have all the factors in their favor to be considered an employee, but a majority in one direction is best in order to qualify one way or another under the tax code.
Whatever category you fall under, it is important to understand why you are classified under that role. Knowing your responsibilities and the liability that accompanies your employment is crucial to ensuring that you not only do your job to the best of your ability, but that you understand the results of your actions, both good and bad.