Job Classifications: Do I Have an Employee or a Contractor?

Before you can properly run payroll for your new hire you need a few key pieces of information; pay rate, pay frequency, cost center assignment, personnel information, and preferred method of payment are all obvious components of running payroll, but what about the classification of your relationship with the person performing work? Knowing whether or not you have an employee or a contractor is vital when paying the individual for their hours worked. If you have an employee that you have mistaken for an independent contractor you will need to audit your information and withhold the appropriate taxes from their wages. Not sure what the difference between a direct hire and a contractor is? Keep reading to learn the telltale signs.

Telltale Signs

Let’s start with possibly the easiest way to tell whether you have a direct hire or a contractor: who sets their hours? Typically a contractor will set their own schedules, while a direct hire is told when they will work and at which location. If you’re determining the schedule and location it is more likely you have an employee rather than a contractor, but of course this alone will not determine job classification. When dealing with an independent contractor the employer can control the result of the work, but not what or how it will be performed. For example, as long as the end result is the vision set forth by the employer, the independent contractor can choose their own methods to get that result. This means they can do the work themselves, or if necessary, they can hire assistants to complete the project. Also, an independent contractor is typically bound to a project or has a certain length of time to complete their job. Because of this, they cannot quit without penalty. An employee can quit or be fired at any time for any reason (as long as it is not discriminatory).  

Who is in Control?

Behavior control, financial control, and type of relationship are the three ways the IRS defines control when determining whether you have an employee or an independent contractor. 

The right to control the details of the work being done is known as behavioral control. The amount of instruction given such as when, where, and how the work is being done are included in determining behavioral control. These details alone, however, do not determine your relationship; the IRS doesn’t need you to necessarily exercise your right to control in order for the worker to be an employee, but simply having the ability to control this is sufficient. Another key aspect of behavioral control is whether or not the person performing the work has regular training by the person receiving the work. If training occurs on a regular basis, you are thought to have an employee-employer relationship.

Financial control has a handful of factors that are looked at before a conclusion can be drawn. Basically, the IRS wants to see if the business has the right to direct and control various economic components of the job being performed. The factors that are looked at to determine financial control are as follows:

  • Profit or Loss: If the individual performing work can make a profit or suffer a loss, they are considered an independent contractor. 
  • Services Available to Public: If the worker offers their services to the public, this indicates they may be an independent contractor. Keep in mind you can also have an employee who does freelance work on the side. 
  • Significant Amount Invested: Independent contractors typically have more money invested due to the equipment they use to perform their duties. 
  • Unreimbursed Expenses: Employees are less likely to have unreimbursed expenses than an independent contractor. For example, if an independent contractor needed to purchase a tool to perform the job, they would not be reimbursed by the business receiving services. 
  • How the Worker is Paid: Employees are typically paid by the hour, week, or month, while an independent contractor typically receives pay at the completion of a job. Please note that some independent contractors do receive hourly pay, such as a lawyer or an accountant. 

Type of relationship is the final factor considered by the IRS in determining control. Type of relationship is broken down into four pieces: a written agreement exists, employee benefits are paid, term of relationship, and if the services are an important part of the business’s normal operations. 

A written agreement is great because it will lay out the relationship between the business and the individual performing the services. Employee benefits such as paid vacation, health insurance, 401(k), etc. are important because it provides evidence that an employer-employee relationships does in fact exist. If a 'terms of relationship' agreement exists, that is typically looked at as an independent contractor relationship. This is because the terms usually elude to the relationship terminating after a job is completed or once a specific length of time has passed. If there are no parameters such as timeframe or job completion laid out around a job, it is likely an employer-employee relationship. The final factor for type of relationship is if the worker’s services are an important part of the normal business operation. If an individual contributes to the key aspects of the business, the individual is likely an employee due to the control factor. 

Common Law Test

Now that we know what control means in the eyes of the IRS, we can determine through the ‘Common Law Test’ whether or not you have an independent contractor or an employee. The Common Law Test states that 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 does in fact exist and that individual is by definition, a common law employee. Notice it states ‘if an employer has the right’, not if they exercise that right, but simply if they have the right. On the other hand, if an individual is under the control of someone else only as far as the results are concerned and not bothered with the details, they are not considered a common law employee. Common Law is simply based on the amount of control an employer has over the individual performing work. 

What Defines an Employee or an Independent Contractor?

There is no single definition as to what qualifies as an employee. You can see by now that there are many moving parts to consider when trying to determine whether someone is an employee or a contractor. This is why the IRS relies on the Common Law Test. The results from this test will aid you when it comes to withholding employment taxes such as social security, Medicare, and more. However, even if you determine you have an employee under the Common Law Test, you should be mindful of the Reasonable Basis Test. Reasonable Basis tells us that even if you have a common law employee, they can still be treated as an independent contractor by the employer. Doing so would make them exempt from federal payroll taxes if you have ‘reasonable basis’ as stated by the Revenue Act of 1978. 

Reasonable Basis:

  • 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 a similar situations as independent contractors. 

To claim reasonable basis, an employer must be consistent for the time frame being questioned. If they are claiming they indeed do have an independent contractor, the employer must file all federal taxes and information to prove their statements.

All-in-all you can see a lot goes into determining job classification. If you’re still unsure about whether you have an employee or an independent contractor consider consulting an employment lawyer.


Source: The Payroll Source, 2016 Edition