Employees vs. contractors: Get classification right

John Hildebrand

Does your business hire outside workers for some jobs? This could result in significant tax breaks if the workers are properly classified as independent contractors rather than employees.

The key point is this: If a worker is an employee, your company must withhold federal income and employment taxes from his or her wages. Your business also is responsible for paying the employer’s share of federal payroll taxes. Conversely, if a worker is properly characterized as an independent contractor, your company isn’t liable for these payroll tax obligations. Moreover, employers aren’t required to offer independent contractors the same benefits regular employees receive, which can result in extra savings.

It’s not always easy to distinguish independent contractors from employees, however. The IRS and courts consider several factors, but it often boils down to a control issue. If you control how, where and when the worker does the job, he or she is usually classified as an employee.

The IRS continues to crack down on business that hire independent contractors when they’re actually employees. If the tax agency reclassifies a worker as an employee, you could be slapped with hefty bills for back taxes, interest and penalties. Audits by state agencies also are common and frequently occur when independent contractors apply for unemployment or workers’ compensation benefits.

Unfortunately, no single factor determines a worker’s status. In one case involving a trucking company, a tax court evaluated seven questions:

What degree of control does the business exercise? Under this test, the court examined how much control the company exerted over the way services were performed. Exercising control isn’t required in an employer-employee relationship, the court noted, as long as the company has the right to direct a worker if necessary.

Which party invests in work facilities used by the individual? The fact a worker provides his or her own tools generally indicates a non-employee status, the court noted.

Does the individual take any financial risk? A worker’s opportunity to earn a profit and assume risk of loss could indicate a non-employee status, the court stated.

Can the business discharge the individual? Generally, an employer’s right to discharge an employee indicates an employer-employee relationship, the court noted.

Is the work an integral part of the company’s regular business? An employer-employee relationship is supported when workers perform a service essential to the success of a business operation.

How permanent is the relationship? The court ruled a transitory work relationship could point to a non-employee status.

What kind of relationship do the parties believe they’re creating? Entering into a written agreement that states a worker is an independent contractor indicates a non-employee relationship. A contract alone is not enough, however. If an employer-employee relationship exists, characterization by the parties as some other relationship is immaterial, according to the court.

In the payroll industry, we run into a high number of businesses that classify all their workers as independent contractors. They make an agreement and even sign a contract. The trouble is, you can’t simply make someone an independent contractor. It’s the nature of the relationship that determines the classification. 

Here is where risk comes into play. The law requires that all employees be covered by workers’ compensation insurance paid by their employers. If you decide you’re going to make your workers independent contractors and they’re in fact found to be employees because of the relationship you have with them, you’re at extreme risk. If one of them is injured on the job, the business owner will be held fully liable for the entire cost of the injury and any disability that follows as a result of the injury. A lawsuit of this type could end the enterprise you’ve worked very hard to create

The bottom line in all of this is that you really have to do your homework. If you’re not sure if the people you hire should be classified as independent contractors or employees, consult an expert. Don’t lose everything you’ve worked so hard to build in an effort to save some money. It’s not worth it.