Randy J. Elder, CPA, P.C.

Independent Contractor or Employee? A Mistake in Classification Can be Costly

More and more small businesses are using independent contractors, freelancers and virtual employees to round out their workforce. There are many benefits and a few drawbacks to using independent contractors. Generally speaking, when you go the independent contractor route you will have a much bigger talent pool to draw from since your independent contractor can be located anywhere around the world.

Independent Contractor or Employee?

Also, you may be able to find more highly skilled resources at lower rates than when you hire an employee. Of course, there are the expense savings that come from hiring independent contractors versus employees. These include savings on vacation, sick pay, health insurance and retirement funding. Businesses also save when hiring independent contractors by eliminating the employer’s matching share of Social Security and Medicare payroll taxes and eliminating unemployment taxes and worker’s compensation insurance.

Technology has made the independent contractor and remote worker a viable option for many business functions. However, technology has also helped to blur the lines between who is an employee and who is an independent contractor.

Hiring independent contractor

One of the biggest drawbacks to hiring independent contractors is the potential for misclassifying an employee as an independent contractor and the associated penalties that can be assessed for making this mistake. If you are thinking of hiring independent contractors, you’ll want to review the determination rules below to make sure you classify your worker accurately. Additionally, I suggest that you implement a regular review of the worker’s classification to avoid any unpleasant surprises. If you find a great independent contractor and a long-term relationship evolves, you want to be aware of any substantive change in the relationship that could change the classification.

If you are challenged on that classification by the IRS or your state taxing authority, and lose, you will be required to pay back all of the savings plus penalties and interest. Your company’s retirement plan could also be in jeopardy of losing its qualifying status if workers who should have been eligible to participate have been excluded from the scheme.

Now that I have your attention, there are three primary characteristics the IRS uses to determine the relationship between businesses and workers: Behavioral Control, Financial Control and the Type of Relationship. Answer the questions below to help determine the correct worker classification.

If you direct or control how the work is done and the financial and business aspects of the job and you perceive the relationship as more employer-employee, you may want to either reclassify the worker as an employee or change the nature of the work to ensure it meets the litmus test for independent contractor classification. Additional factors that are taken into consideration in making the determination of worker classification include;

Sole Employer

Independent contractors usually have multiple clients. If the worker in question only works for your business and does not pursue additional clients, this would be an indicator favoring employee classification. Keep an eye on this especially if the number of hours worked approaches full-time.

Work Schedule

Independent contractors generally set their work schedule. If you require regular hours of the worker, this would be an indicator supporting employee status.

Materials and Supplies

Independent contractors provide their materials and supplies. If you are providing these for the worker, it is a sign backing employee status.

Work Location

If you use remote workers, this is not an issue but if you prefer local employees you’ll want to make sure they perform the majority of work at their office. If you require them to use your office, it can be an indicator favoring employee classification.

If you currently use independent contractors or are considering it and you are uncertain about the worker status determination, please give me a call.