June 2021
Contractors and Employees: What is the difference and why is that important?

If you are starting your business or looking to expand, you may wonder whether to hire employees or work with contractors.

This article’s aim is to help you make an informed decision and avoid the potential consequences of misclassification.

What is Worker Classification?

It’s usually easy to classify a worker as your employee or an independent contractor. But sometimes the decision is difficult and might go either way.

For the IRS, the difference between employees and independent contractors is a matter of “classification.” If the person you hire is not classified correctly, the IRS views that as a matter of “misclassification.”

Intentional misclassification of an employee as a contractor, or vice versa, is a crime that can have serious legal and financial consequences.

Why is Worker Classification Important?

It’s important to know the difference between contractors and employees so your business can stay compliant with important tax and employment laws.

The way a business pays and withholds taxes differs for employees and contractors. The difference can have a substantial effect on a company’s finances.

Employee Tax Withholding

For employees, an employer must:

• withhold income and FICA taxes from the employee’s paycheck. FICA stands for the “Federal Insurance Contributions Act”, the federal law that requires employers to pay and withhold social security and other taxes from an employee’s earnings,
• pay those taxes to state and federal governments on the employee’s behalf,
• match the FICA taxes paid (this is known as the “employer’s contribution”).

Then, at the end of the tax year, employers must send a completed W-2 form to all employees so they can complete their personal tax filing.

Contractor Tax Withholding

Generally, companies need not withhold taxes for their independent contractors. This is because the vast majority of contractors operate as self-employed workers and pay all of their income and FICA taxes themselves.

When hiring a contractor, you simply ask them to fill out an IRS W-9 Form. Then, at the end of the tax year, you send IRS Form 1099 to the contractor and the government.

The Risks of Worker Misclassification

Because costs of payroll services and tax obligations are more with employees than with contractors, some businesses are tempted to misclassify employees as contractors.

If the IRS discovers a company has done this, and if it disagrees with the company’s classification decision, not only may the company be liable for back taxes, but the company could also face severe penalties, depending on whether the misclassification was a mistake or intentional.

Also, if one of your contractors fails to pay required taxes, the IRS may come to you for the amounts owed, claiming the contractor was really an employee.

It’s therefore critical for a business owner to correctly determine and document whether those who provide services for the business are contractors or employees.

Here are important factors to consider when classifying contractors and employees:

Contractors

According to the IRS, an independent contractor is someone you hire to perform work and you control only the result of the work and not how it will be done.

Most contractors are working professionals who own and operate their own business to perform tasks for other businesses. Consultants, accountants, website developers, carpenters, custodians and other professional service providers are common examples of contractors. They:

• work on their own terms to complete a task,
• set their own hours (even though a deadline is often part of the contract),
• use their own equipment and tools,
• are self-employed and pay self-employment taxes.

Employees

For the IRS, an employee is anyone who performs services for you when you control the details of how they do their work.

Employees are compensated with hourly wages, an annual or monthly salary, commissions, other benefits, or a combination of the above, and you:

• set specific working hours (i.e., Monday - Friday, 8am - 5pm),
• supply equipment for their work, such as computer, desk, and phone,
• provide training to handle certain responsibilities,
• offer benefits such as paid vacation time, health care and retirement plans.

How to Make the Right Classification

In close cases, there are several things to consider when classifying someone as an independent contractor or employee. Here are questions to ask yourself:

1. Who Controls Worker Behavior?

The first and most important factor determining whether a person is an employee or a contractor is behavioral control. When it comes to employees, the employer has significant control over how a particular job is done. For example, an employer may:

• offer on-the-job training and instruction,
• provide employees with work-related equipment or software,
• set specific working hours.

These and other similar factors almost always demonstrate an employer-employee relationship.

But a contractor will typically;

• bring their own expertise to the job with no training required,
• use their own equipment,
• set their own work hours, but with a contract deadline in mind.

2. Who Determines Financial Compensation?

The next factor is financial control. When hiring an employee, the employer has all control over how the employee is compensated; the employer can freely give raises or bonuses, or even make pay cuts if the worker doesn’t perform.

With a contractor, however, financial compensation is usually arranged by contract on a per project basis. It’s common for multiple contractors to bid for a project, and then the paying company selects which contractor to hire. Once terms are set, both sides must abide by a contract between them.

In this way, contractors control their own compensation by limiting their hours and expenses to only those necessary to complete the project consistent with the contract.

3. Common Factors Making the IRS Reclassify Contractors as Employees.

For the IRS, some things always suggest an employer-employee relationship – avoid these as best you can when working with contractors:

• providing coverage of any kind under your insurance policies,
• offering benefits, such as paid vacations or gym memberships,
• paying a monthly or annual salary not directly tied to a specific set of projects,
• insisting that the contractor not do business for others while working on your project.

Protection Against Misclassification

There are many ways to avoid the risks of worker misclassification; here are three:

1. Document Decision Factors

Record why you made a worker classification. This will not only help you make a reasonable choice, but also help you defend your decision if the IRS challenges it.

Most hiring decisions are straightforward and do not require extensive documentation. But keeping a written record of classification factors – especially when you believe the decision may be borderline – could be especially helpful.

2. Collect Documentation from the Worker

If you do classify a worker as a contractor, collect from them copies of documentation, such as:

• business forms filed with the Utah Department of Commerce, such as a DBA (“Doing Business As”) form; these will help show the contractor operates a business separate from yours,
• business or professional licenses they hold,
• insurance policies showing they have their own coverage
• a list of other businesses the contractor has serviced
• business cards and other advertising materials portraying them as a contractor.

3. Have a Written Agreement

A written agreement with your service provider will typically outline the factors used to classify him or her as a contractor or an employee. If the IRS challenges your classification of an employee as a contractor, your written agreement with the service provider will be the first thing asked for.

Conclusion

Unfortunately, the distinction between independent contractors and employees is not always clear; there is no “magic” formula to making the worker an employee or an independent contractor. In close cases, several factors come into play, and no one factor stands alone in making the determination.

Use care when classifying your workers. Seek guidance – from the IRS, your certified public accountant and a lawyer – when in doubt.

I hope this short summary helps you better understand the current employer landscape regarding contractors vs. employees.

–Robert A. Youngberg