Know the Difference Between an Independent Contractor and Employee

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Pete Real

In the modern economy we’ve seen widespread movement toward outsourcing and use of contractors, including the increasing prevalence of services like Uber. There are certainly advantages for businesses, as employees come with a number of financial and reporting requirements, such as withholding and reporting federal, state, and local income tax and payroll taxes; paying the employer share of FICA taxes; paying federal and state unemployment insurance assessments; paying worker’s compensation insurance premiums; and providing benefits ranging from health insurance to paid time off. However, while independent contractors are less complicated and in most cases less expensive, the penalties for misclassifying a worker who should legally be an employee can be stiff—especially if the IRS determines that the company did so intentionally rather than inadvertently.

The challenge arises from the fact that there is no “bright-line” test for classification. What the IRS provided to its agents in the past was a list of factors that were sometimes applied in court cases and became known as the 20-Factor Test. Some of those factors are rather dated today, and the IRS now directs its agents to analyze the “overall situation” rather than marking boxes on a checklist. The bottom line is that if your business makes an independent contractor determination in a borderline situation that is later challenged, the outcome will likely come down to the judge’s assessment and how capable an attorney you hire.

Classification Testing

Control is the main issue in question. Keep in mind that a true independent contractor is a business, albeit a one-person business, so your dealings with them should resemble a vendor relationship. Behavioral control involves the degree of control the business has over how a given task is executed. An employee is subject to specific directions regarding when, where, and how work is to be done; an independent contractor must have a much greater degree of latitude. Requiring a contractor to perform work at your business location is a push into employee territory, especially if it is a type of work that could easily be done from the contractor’s home or other location—copywriting or financial analysis, for example.

Training is another behavioral control issue. Employees are often trained how to do a task, but in general a contractor is expected to already have the knowledge to accomplish the task for which they are hired. This can be a particularly challenging gray area, however, since companies often have specific procedures or constraints such as custom software that would require some degree of instruction for anyone performing certain tasks.

Questions of financial control tend to be much clearer. First, a contractor should have unreimbursed business expenses, and in particular ongoing costs incurred whether the contractor is working or not. These could range from office rent to software subscriptions to certain types of insurance premiums, such as errors and omissions (E&O) coverage. Second, a contractor may have a significant investment in equipment, software, or other things needed to perform work, although many of today’s “knowledge-based” occupations don’t create this requirement. Third, it should be possible for a contractor to incur a loss as well as generate a profit. In many cases the contractor’s ongoing costs will not be satisfied by revenue from a single client.

The nature of the relationship is one of the easiest factors to define. A written contract will clearly indicate whether an employee or independent contractor relationship exists, so—hint, hint—always use written agreements for contractors. (This is not a get-out-of-jail-free card, however; you may contractually define someone as a contractor, but if based on all the factors the relationship is clearly an employer-employee one, what that contract says will not matter.) Also, the existence of benefits normally provided to employees, such as insurance, paid time off, or a pension plan, is a clear indicator of employee status.

Don’t Assume

Businesses sometimes fall into the trap of assuming that someone is a contractor because certain conditions exist. Don’t assume—the following factors don’t automatically make someone a contractor.

  • The person specifically asked to be an independent contractor.
  • The person does not work regularly but is instead on call or works an irregular, sporadic, or unpredictable schedule.
  • The person is paid on a commission-only basis.
  • The person works for more than one business.
  • The person signed a contract identifying him or her as an independent contractor. (We felt like this one deserved repeating.)

Protecting Yourself from Misclassification

If you have any doubt about classifying someone as a contractor, consult with a labor attorney. You can also file Form SS-8 with the IRS and request a determination. Although this determination is valid only for IRS purposes—it does not necessarily mean another agency such as the Department of Labor will reach the same conclusion—it does show that you attempted in good faith to comply with the law. If by now you’ve begun wondering whether some of the contractors doing work for you are actually employees in the eyes of the law, the IRS offers a Classification Settlement Program. There is also a safe harbor provision in Section 530 of the Revenue Act of 1978. As with any other matter, it is far better for you to approach the IRS with a possible violation than for them to come to you.

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