Employees and independent contractors all play important parts for small businesses across the country. While they can both work for the same company, there are key differences between the two.
Why does proper employment status matter? There are important legal differences between employees and independent contractors that affect payment, protections, and other key HR matters. In addition, improper employee classification can lead to serious penalties from the IRS. Here’s a breakdown on what differentiates independent contractors and employees and how it can impact a small business.
How to Determine the Degree of Control Through Common Law Rules
Control is a major factor in what separates an employee and an independent contractor. While employers maintain some control over employees, independent contractors maintain a level of independence. According to the IRS, there are three different categories of control that can help you determine if someone is an employee or an independent contractor.
Behavioral Control
The level of control an employer has over how projects are completed is a good identifier for proper classification. The IRS names four different factors that fall under behavioral control.
- Type of instructions given
- Degree of instruction
- Evaluation systems
- Training
Types of Instructions Given
In terms of instructions, these are directives that employers can give to employees about when, where, and how work should be done. This can include commands on what equipment an employee uses, the order which tasks are done, and where to purchase supplies. Employees are subject to these instructions, while independent contractors have freedom to complete tasks how they see fit if it meets the conditions in their contract or scope of work (SOW).
Degree of Instruction
The degree of instruction also plays a factor. In general, the more detailed an employer’s instructions are, the more likely it is that a worker will be considered an employee. However, this can vary depending on the nature of the work and level of expertise for both the professionals and contractors. According to the IRS, “the key consideration is whether the business has retained the right to control the details of a worker's performance or instead has given up that right.”
Evaluations
If done, evaluations also can share insight into whether an employer’s degree of control, mainly in terms of how in depth an evaluation is. Evaluations that only consider end results don’t shed much light on the matter. However, an evaluation that studies specific details of how someone completes a task can be evidence that the worker in question is an employee.
Training
If an employer requires training, it’s a strong indication that the person being trained is an employee. This is because training is evidence of control, as it means that the person will learn how an employer wants the job in question to be completed while independent contractors typically have some form of outside training.
Financial Control
Another factor of control involves the economic aspects of a job. The IRS designates five different financial control factors that help determine if someone is an employee or and independent contractor.
- Significant investment
- Unreimbursed expenses
- Opportunity for profit or loss
- Services available to the market
- Method of payment
Significant investment
While included as a control factor, significant investment can be hard to determine. Both independent contractors and employees can spend notable sums to acquire equipment necessary to complete a job. Instead, significant investment plays a bigger role when combined with some of the following factors.
Unreimbursed expenses
If an employer reimburses someone for work expenses, that’s generally a sign that the person in question should be considered an employee. It’s not uncommon for independent contractors to incur similar expenses, but they will generally won’t be repaid. However, there are situations where employees aren’t repaid for expenses, so a lack of reimbursement isn’t necessarily a determining factor.
Opportunity for profit or loss
A sign that someone is an independent contractor has more opportunity for both profit and loss. If a contractor is already set up with the necessary equipment, he or she can make a greater profit. However, that contractor may also have a job where the investment outweighs the income, resulting in a loss. Employees have a much more stable income and typically don’t need to deal with the ebbs and flows of investment costs.
Services available to the market
An employee won’t have to market the availability of their services to you; they’ll simply do their job. However, independent contractors typically make their services available on the market and float from job to job. Note that an employer can have an employee who freelances outside of work hours. In this situation, that person is still considered an employee of the company in question, but any business this employee freelances for on the side, would classify this person as an independent contractor.
Method of payment
Employees have a regular payment schedule, whether it’s a base salary that’s paid out in set increments of time or an hourly arrangement. Independent contractors are usually commissioned for a set amount of work. This can be a flat fee that’s delivered at the completion of a project or an hourly agreement. For example, a freelance editor or a lawyer can set a specific hourly rate and you could pay this person for 10 hours of work.
Type of Relationship
An employer’s relationship with a worker is a key part of proper classification. According to the IRS, there are four different identifiers employers should consider:
- Written contracts
- Employee benefits
- Permanency of the relationship
- Services provided as key activity of the business
Written contracts
The existence of a contract is not a determining factor for either employees or independent contractors, even if it states that someone is either classification. Instead, the IRS reviews the nature of the employer and the person in question’s relationship to measure their actions instead of written language.
Employee benefits
In general, if a worker receives benefits from an employer, they are considered an employee. Independent contractors are considered self-employed and are not privy to be a part of an employer’s benefits package. However, the lack of benefits doesn’t mean that someone must be an independent contractor, as a business may not necessarily offer any benefits package to their employees.
Permanency of the relationship
Employers don’t hire employees with the expectation that these employees won’t work for them after a short period of time. While independent contractors are generally temporary solutions for businesses, the IRS views any work relationships are meant to be indefinite as that between an employee and employer.
Services provided as key activity of the business
The services that independent subcontractors provide are typically important, but not critical, for a business’ success. However, if an employer hires someone to provide a service that’s the IRS considers a “key activity of the business,” it may view the relationship as that between an employee and an employer. In this definition, a key activity is part of the main services a business provides, such as if an electrical company hired an electrician for regular side work. In this instance, the IRS would view this as a part-time employee instead of as an independent contractor.
How Employee Classification Impacts HR Management
Once someone is determined to be an employee or and independent contractor, an employer can use this information to make sure they stay in compliance with any government regulations. The classification status of a worker impacts several HR functions ranging from financial considerations to employee protections.
Payroll Tax Management
The classification of a worker has a direct impact on how their taxes are handled. If someone is considered an employee, an employer is responsible for withholding and depositing their payroll taxes. Employers are required to have employees provide their social security number and complete Form I-9 for employment eligibility and Form W-4 for employee’s withholding. The employer will then report what an employee earned during the year on Form W-2 and send copies to both the employee and the IRS by Jan. 31.
Independent contractors need to complete Form W-9. This will allow employers to confirm the potential contractor’s name and receive his or her Taxpayer Identification Number. After a contractor works for an employer, that employer provides both the contractor and the IRS with a completed Form 1099-MISC by Jan. 31. While employers are not responsible for payroll taxes with contractors, they must report the payments made to the contractor for their own tax purposes. However, if a contractor was paid less than $600 during the year, no Form 1099-MISC is required.
How and When They’re Paid
The payment process for employees is fairly straightforward; employees are paid either hourly rates or with a base salary. Their wages are then paid out on set dates that range anywhere from one week to one month apart.
Payment for independent contractors largely depends on the stipulations provided in a contract or SOW. Both parties can agree to varying payment structures and fees, whether it’s an allotment of hours for work or a flat fee. In terms of when contractors get paid, that’s another matter that should be stated in writing. Some contractors will split fees up, such as requiring half the fee up front and half upon completion of the project. Others will set payment due dates at certain milestones, such as within 60 days of completion.
Employment Laws and Protections
If a worker is considered an employee, they are protected by the various national and state employment laws that exist. However, that arrangement doesn’t extend to independent contractors. Since they’re not an official employee of a business, independent contractors are not eligible for many of the same benefits and regulations that cover regular employees. These include unemployment compensation, worker’s compensation, workplace safety laws, and other similar protections.
Protect Your Company Through Expert HR Management
As an Employer, you have the final call on who to hire, whether someone will be an employee or an independent contractor. You’re also on the hook to make sure that everything your business does is up to legal standards. Between payroll management, benefits administration, and other HR functions, that’s a lot of work and responsibility, with little time left for core business functions.
A Professional Employer Organization allows small business owners to share the burden and strengthen their business at the same time. PEOs give small business access to a team of HR experts that can efficiently and effectively manage key HR functions, including proper employee classification. Contact GMS today to talk to one of our experts about how a PEO can help you save time and protect your business.