Content Updated July 18, 2018
Determining employee classification is a vital part of running your business. It can be easy to confuse an employee for an independent contractor and vice versa, but doing so will cause you a lot of problems later on. Let’s take a close look at the differences to avoid penalties and fines.
Employee vs. Independent Contractor Definition
Unfortunately, there is no single definition as to what classifies one as an employee, and this can blur the lines a bit between employee and contractor. However, the IRS relies on the Common Law Test to determine whether employment taxes such as social security, Medicare, and so on should be withheld from an individual’s pay.
The Common Law Test
Common Law states if an employer has the right to control what work will be done and how that work will be done, then an employer-employee relationship exists and the worker is indeed a common law employee. It is important to note that this individual is an employee under the common law test even if the employer does not exercise their right to control. Conversely, if an individual is under the control of someone else only as far as the results go, and not in control of how the work is accomplished, they are not considered an employee under the common law test. It all comes down to the amount of control the employer has over the individual performing work.
What is Control?
If the common law test determines whether or not you have an employer-employee relationship or that of an employer-independent contractor relationship, we need to know just what ‘control’ means. The IRS has constructed three categories to determine control: behavioral control, financial control, and type of relationship.
Behavioral control refers to the right to control the details of the work being done. This includes the amount of instruction given to the worker as far as when, where, and how to work. As mentioned before, an employer doesn’t necessarily have to exercise their right to control in order for them to be considered an employee, but the simple fact that they have the ability to is sufficient enough. Another key component to behavior control is the training aspect of the job. If an employer is providing training on a regular basis, they are considered to have an employer-employee relationship.
Financial control has a few different layers to it, but to sum it up the IRS is looking to see if the business has the right to direct and control certain economic factors of the individual’s job. The five factors that go into determining financial control are:
Unreimbursed Expenses: Independent contractors are more likely than employees to have business expenses that are not reimbursed.
Significant Amount Invested: Typically, independent contractors have much more invested in the equipment used to perform the job.
Services Available to Public: If the worker offers their services to the public this indicates the individual may be an independent contractor.
How Worker is Paid: Typically an employee is paid by the hour, week, or month, while independent contractors are paid upon completion of a job. However, certain independent contractors will be paid an hourly rate as well, such as lawyers or accountants.
Profit or Loss: If the individual is able to make a profit or incur a loss they are an independent contractor.
The final piece in determining control is the type of relationship. There are four factors that will give insight into whether or not an individual is a contractor or an employee. The four factors are: if a written agreement exists, if employee benefits are paid, term of relationship, and if the individual’s services are an important part of the business's normal operations.
A written agreement is important because it will advocate pretty clearly the relationship between the business and the worker.
The next factor, employee benefits, is important because if an employer provides benefits such as paid vacation, health insurance, etc. that is evidence of an employer-employee relationship.
Next is the term of the relationship. If an employer hires an individual to complete a project, or for a specific period of time that is an indication of an independent contractor. If the individual is hired without any timeframes around the employment that show the intent of an employer-employee relationship.
The last factor in the type of relationship is the worker’s services being an important part of the normal business operations. If an individual contributes to the key aspects of business activity, it is thought that the employer will have the right to control, therefore making that individual an employee.
Reasonable Basis Test
Just when you think you have it figured out you realize there is such thing as a reasonable basis. The reasonable basis test says even though an individual may meet the definition of an employee under the common law test, they can still be treated as an independent contractor by the employer. This means they would be exempt from federal payroll taxes if the employer has ‘reasonable basis’ as stated by the Revenue Act of 1978. A few factors go into determining whether reasonable basis is present.
A court decision, IRS rulings, IRS technical advice letter received by the employer, or a private letter from the IRS that indicates the worker is not an employee.
A past audit by the IRS of the employer that did not show taxes owed or a penalty attributable to the employer’s treatment of the worker as an independent contractor.
A longstanding, recognized practice in a significant segment of the employer’s industry of treating workers in similar situations as independent contractors.
To claim reasonable basis, an employer must be consistent with the time frame being questioned. This means if they are claiming they indeed do have an independent contractor, the employer must file all federal taxes and information to prove their statements.
For more information on classifying your workers, please visit the IRS website.
Source: The Payroll Source, 2016 Edition