Contractor or employee? Know the differences

Janet Arrowood

If you own a small business, you’re probably always looking for ways to reduce your operating expenses and payroll while still providing stellar service to customers.

One approach many business owners take is to hire people as independent contractors (IC) to avoid paying workers’ compensation premiums, payroll and other taxes, unemployment insurance assessments and accounting expenses related to having employees. Beware, though:  There are risks with significant potential penalties as well as other implications if you misclassify someone as an IC when he or she is really an employee.

Why is it important to know whether the person who works for you is an IC or employee? Here are five good reasons:

The answer determines if he or she must be covered by your workers’ compensation policy.

The answer determines whether or not you have to withhold taxes and make the employer contribution to Social Security and Medicare.

The answer determines whether or not you have to pay unemployment insurance premiums for that person.

If you misclassify the person, you could find yourself facing unpleasant and expensive consequences at both the state and federal levels.

If the person is an IC, your business doesn’t have to provide employee benefits or paid time off.

So how can you tell?

According to the Colorado Workers’ Compensation Act, “anyone who performs work for you is an employee, unless he/she is free from control and direction in the performance of the service; is customarily engaged in an independent trade, occupation, profession, or business related to the service provided; [and/or] has no workers.”

Here are some of the steps to take to determine if the person is an IC. Note: The person’s business could be a corporation, limited liability company or other business entity with a single employee — the person with whom you’re contracting.

Ask the prospective IC and yourself:

Is the person under your control or direction? If the answer is yes, stop. This person is not an IC. They’re probably your employee.

If the answer is “no,” ask if the person is “engaged in an independent trade, occupation, profession or business.” This generally means they have other customers. If the answer is “no,” they’re probably your employee. If the answer is “yes,” verify the following: the person has a (state-registered) business name, carries business liability and related insurance, offers services to other businesses, submits invoices, supplies equipment and transportation and works alone. If the answers to all of these are “yes,” the person is probably an IC. Note: Many ICs don’t carry business liability insurance, although they really should.

Finally, do invoices specify payments be made to the business name and account? Do you pay the person a contracted rate?

If you answer “no” to the first question and “yes” to the remaining questions, the person most likely is an IC. You’re probably not required to cover him or her under your workers’ compensation policy, withhold payroll taxes, make the employer’s contribution to Social Security and Medicare or pay unemployment insurance assessments.

As an additional consideration, check the IRS website and download the SS-8 form. This is a form you can use to help you determine, from the federal perspective, whether or not someone is an IC. If it’s later determined the person was your employee rather than an IC, you might be liable for back benefits.

Another important note: Make sure to get a copy of the IC’s certificate of workers’ compensation insurance coverage or a copy of the waiver they filed.

For more specific, Colorado-related information, visit the website at www.pinnacol.com/knowledge-center/employee-or-independent-contractor. For federal-related information, log on to www.irs.gov/forms-pubs/about-form-ss-8.

Note: This article is only for informational purposes. It is not intended as tax, legal or insurance guidance or advice. Always consult the appropriate professionals when making legal, tax or insurance decisions.