How Independent Contractors Are Different from Employees and Why You Should Care
Mischaracterizing an employee as an independent contractor can have severe consequences. This blog discusses what an independent contractor is, how they are different from employees, and why you should care if you own and operate your own business or have similar interests. Further, this blog briefly details what tests the government uses to identify independent contractors so you can avoid liability for mischaracterizing an employee.
For federal employment tax purposes, a business must examine the relationship between the business and the worker. The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done. Small businesses should consider all evidence of the degree of control and independence in the employer/worker relationship.
Why is it important to correctly classify employees and independent contractors?
Businesses do not have to pay minimum wage or overtime to laborers classified as independent contractors, and are also not subject to discrimination, sexual harassment, health insurance coverage requirements, unemployment tax, wrongful termination, and workplace injuries laws. The earnings of a person working as an independent contractor are subject to self-employment tax. Because these costs are avoided, employers are often tempted to classify their workers as independent contractors rather than employees.
What happens if I misclassify my worker as an independent contractor?
Classifying an employee as an independent contractor with no reasonable basis for doing so makes the employer liable for the amount of state and federal taxes that should have been withheld from the laborer’s pay, as well as the amount that should have been contributed to welfare programs such as unemployment and worker’s compensation. Certain employers that can provide a reasonable basis for not treating a worker as an employee may have the opportunity to avoid paying employment taxes.
To establish that you had a reasonable basis for not treating the workers as employees, you can show that:
You reasonably relied on a court case about federal taxes or a ruling issued to you by the IRS; or
Your business was audited by the IRS at a time when you treated similar workers as independent contractors and the IRS did not reclassify those workers as employees. You may not rely on an audit commenced after December 31, 1996, unless such audit included an examination for employment tax purposes of whether the individual involved (or any other individual holding a substantially similar position) should be treated as your employee; or
You treated the workers as independent contractors because you knew, and can substantiate, that was how a significant segment of your industry treated similar workers; or
You relied on some other reasonable basis. For example, you relied on the advice of a business lawyer or accountant who knew the facts about your business.
— Publication 1976 PDF, Section 530, Employment Tax Relief Requirements
GLO specializes in employment law and helping businesses properly classify their laborers and develop employment contracts accordingly.
Independent contractor vs. employee — What’s the difference?
An independent contractor is a worker who performs services for another using their own skill and methods, without the direction and control of the employer. Employers have relatively few obligations and responsibilities for independent contractors. In contrast, an employee is hired by the employer for an indefinite period of time and their employment may be terminated by either party with or without cause.
Several government agencies, including the state unemployment office and the federal Internal Revenue Service (“IRS”), govern worker classification. Figuring out how to comply with all of the federal and state laws can be a complicated undertaking.
How does Colorado determine whether a worker is an employee or an independent contractor?
Whether a worker is an independent contractor or employee depends on the facts in each situation. To better determine how to properly classify a worker, consider these three categories – Behavioral Control, Financial Control and Relationship of the Parties.
Behavioral Control: A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. Behavioral control categories are:
Type of instructions given, such as when and where to work, what tools to use or where to purchase supplies and services. Receiving the types of instructions in these examples may indicate a worker is an employee.
Degree of instruction, more detailed instructions may indicate that the worker is an employee. Less detailed instructions reflect less control, indicating that the worker is more likely an independent contractor.
Evaluation systems to measure the details of how the work is done points to an employee. Evaluation systems measuring just the end result point to either an independent contractor or an employee.
Training a worker on how to do the job -- or periodic or on-going training about procedures and methods -- is strong evidence that the worker is an employee. Independent contractors ordinarily use their own methods.
Financial Control: Does the business have a right to direct or control the financial and business aspects of the worker's job? Consider:
Significant investment in the equipment the worker uses in working for someone else.
Unreimbursed expenses, independent contractors are more likely to incur unreimbursed expenses than employees.
Opportunity for profit or loss is often an indicator of an independent contractor.
Services available to the market. Independent contractors are generally free to seek out business opportunities.
Method of payment. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time even when supplemented by a commission. However, independent contractors are most often paid for the job by a flat fee.
Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. This includes:
Written contracts which describe the relationship the parties intend to create. Although a contract stating the worker is an employee or an independent contractor is not sufficient to determine the worker’s status.
Benefits. Businesses providing employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay have employees. Businesses generally do not grant these benefits to independent contractors.
The permanency of the relationship is important. An expectation that the relationship will continue indefinitely, rather than for a specific project or period, is generally seen as evidence that the intent was to create an employer-employee relationship.
Services provided which are a key activity of the business. The extent to which services performed by the worker are seen as a key aspect of the regular business of the company.
How are federal taxes affected by employees v. independent contractors?
An employer must pay Social Security, Medicare taxes, and unemployment taxes on wages paid to an employee, but not for an independent contractor.
The IRS governs federal employment taxes and has a similar test to distinguish between employees and independent contractors. The IRS test looks to the level of control an employer has over a worker and how the employer and worker both perceive their relationship. In addition, workers who receive benefits such as paid time off or insurance coverage are typically considered employees under the IRS.
Can an independent contractor get unemployment or workers’ compensation benefits?
Unfortunately, because employers do not contribute into unemployment and workers’ compensation insurance funds by withholding portions of wages for independent contractors, those independent contractors cannot claim any of those funds if they get hurt on the job or laid off.
It is important to know that there is a presumption that employed individuals are employees as opposed to independent contractors. To prove an individual is an independent contractor, they and the person for whom services are performed must show by a preponderance of the evidence that the individual is free from control and direction in the performance of the service. While the parties may prove independence through a document, i.e., contracting agreement, all signatures on any such document must be notarized. The contract must also contain a disclosure in bold, underlined, or large font that the contractor is not entitled to unemployment insurance benefits and must pay state and federal taxes on any compensation paid pursuant to the agreement.
An employer should have a complete and accurate understanding of all facts surrounding the relationship between the employer and the worker, so they can meaningfully apply the various factors used to determine a worker’s classification. GLO will help you determine your worker’s status, so they are classified according to your needs. If you have any questions, fill out an interest form today to see if GLO can help you.
GLO has prepared this blog to provide general information on legal issues that may be of interest. This blog does not provide legal advice for any specific situation and this does not create an attorney-client relationship between any reader and GLO or its attorneys. GLO engages clients only through specific fee arrangements and signed engagement letters. GLO does not guarantee any results.