According to the IRS, employers have misclassified millions of employees as independent contractors. While it does happen intentionally from time to time in order to save money, we like to think that more often than not this is done by mistake due to the confusing, somewhat convoluted, differences between the two classifications. The fines for this misclassification can be quite hefty, especially if it looks like it was done intentionally. That is why it’s vital that you are sure whether you have hired an employee or an independent contractor. Listed below are a number of ways you can determine if you have an employer/employee relationship on your hands, or if the person in question is an independent contractor. For all you visual learners, scroll to the bottom to find an infographic that summarizes this information for you!
The Common Law Test
As I just mentioned, there is no clear definition of an employee, which is largely why there is so much confusion around the whole topic. The IRS relies on the Common Law Test in order to sort individuals into employees (meaning taxes like social security and medicare, etc. need to be withheld) and independent contractors. Common Law means that the employer has the right to dictate exactly what will be done and how. If this is the case, you have an employee on your hands. However, as clear as that might sound, there’s one very important thing to keep in mind: the individual is an employee even if the employer chooses not to exercise the right to control. Just because you don’t decide what or how something gets done does not mean they aren’t an employee. If you’re still confused, try looking at this the opposite way: if you’re paying for results but not methods, meaning you have no control over what materials are used, then they fail the Common Law test and are likely an independent contractor. It all comes down to control.
How to Determine Control
Now that we’ve (somewhat) cleared up what the Common Law Test looks for (i.e. control), we have to figure out what that means exactly. The IRS has broken down the process of determining control into three categories: behavioral, financial, and connectional.
When we talk about behavioral control, we’re referring to the employer’s right to control the finer points to the work that’s being done. If you have the ability to decide when and where the work is done, as well as how, that’s your biggest inclination that you have control over the individual. Don’t forget what I said about how it doesn’t matter whether or not you exercise the control, you simply have to have it. Another aspect of behavioral control is when looking at the training process. If you’re offering regular, consistent trainings throughout their employment, you likely have behavioral control over them.
There are a number of factors that the IRS looks for in order to determine whether you have financial control over an employee. They are:
- Unreimbursed Expenses: If you are reimbursing business expenses for the individual, they’re likely an employee. Independent contractors will typically have their expenses not be reimbursed.
- Significant Investments: Independent Contractors are going to invest a lot more in the equipment necessary to perform the job, as they will be using it for other jobs down the road.
- Services Available Elsewhere: Employees typically don’t offer their services to the public, whereas independent contractors can do multiple jobs without worry about overlapping commitments.
- Payment Method: Generally, employees are generally paid by the hour, week, or month and contractors are paid upon completion of a job. That being said, certain independent contractors, such as lawyers or accountants, may be paid an hourly rate.
- Incur a Loss: Employees will be paid regardless of most circumstances, but contractors may incur a loss if the job is not completed satisfactorily.
The last method of determining control is deciding the type of relationship. In figuring out what the connection between you and the individual, the IRS will ask four questions:
Does a written agreement exist? This will help clearly state what the intended relationship is between you and the worker.
Are employee benefits paid? If you’re providing paid time off, insurance, and other employee benefits, it is likely that an employer/employee relationship exists.
What is the term of the relationship? If the worker is only involved in so far as the job is completed, the signs point to them being an independent contractor.
Are their services fundamental to the business's normal operations? If the worker’s contribution is key to the business, you likely have control over that individual, thus establishing an employer/employee relationship.
The Reasonable Basis Test
To make matters more complicated than they already are, the IRS has a reasonable basis test. This states that just because a worker meets the qualifications of an employee under the common law test, you may still treat them as an independent contractor. This would have them exempt from federal payroll taxes if you can provide “reasonable basis” that is in accordance to the Revenue Act of 1978. Here’s what goes into deciding whether the reasonable basis exists:
If you have documentation of a court decision, IRS ruling, IRS technical advice letter, or a private letter from the IRS that says the individual is not an employee
You’ve previously had an audit by the IRS that did not suggest you owed taxes or penalties attributed to your treatment toward the worker as an independent contractor.
You have a longstanding practice that is recognized by the IRS of your industry treating workers in similar situations as independent contractors.
If you’re still unsure whether you have an employee or independent contractor, it’s a good idea to visit the IRS website or even contact a professional. The fines behind misclassifying these individuals can be hefty, so make sure you know without a doubt what your relationship is toward your workers. For a visual aid, check out this infographic by clicking below.
Want to see how an applicant tracking software can help you classify your workers appropriately? Request a demo now.