As businesses grow, staffing needs increase. Should an organization hire an employee or independent contractor?
An independent contractor may feel like a part of the team. And their independent status doesn’t mean they can’t — or shouldn’t — be a major contributor to the company’s goals and culture. But there are important distinctions between an employee and an independent contractor. Misclassifying an employee as a contractor can result in significant tax penalties, you don’t want to be on the wrong side of the IRS’s definition.
This article examines the differences between an employee and an independent contractor. We start with a basic definition, before moving into the common law test often used to make a determination as well as more recent trends impacting the differences.
The simplest definition is that an employer needs to withhold payroll taxes such as income taxes, Medicare and Social Security for an employee, but not for an independent contractor. So while an employee and a contractor might be paid the same, the responsibility for withholding taxes falls to the contractor.
That also means there are different tax forms for independent contractors you’ll need to gather. At a minimum, this includes a W-9 and a Form 1099-MISC if you pay the contractor $600 or more in a year.
Furthermore, contractors are typically not covered by labor laws, they operate independently of the hiring entity, and usually don’t receive health benefits.
While these definitions are helpful, they do not necessarily demonstrate how to determine which category your employees belong to. For this, we have to look at something called the Common Law Test.
The common law test helps employers categorize their workers as independent contractors or employees. According to the IRS, one of the most important points is whether the employer is only able to control the results of the work or if they are allowed to have input on how the work is performed as well. The key factors of the common law test look at the type of relationship between the parties, who determines the behavior, and who has financial control.
In general, if the employer has the right to control what work will be done (even if they do not exercise that right) and how that work will be done, then that individual should be classified as an employee under the common law test. But if an individual determines how best to complete a job and is only told what needs to be accomplished, he or she would likely be classified as an independent contractor.
It’s worth taking a look at an example of how this would be applied. So, for instance, let’s consider how an employee vs. an independent contractor would replace a window:
If you want a deeper dive, check out this course from the Social Security Administration on how to apply the common law test.
Hiring contractors can result in lower employer taxes, but it’s important to properly classify the worker, or significant tax penalties can be imposed. The common law test looks at who controls the behavior, who has financial control, and the relationship of the worker with the business in determining the employee classification.
The short answer is “yes.” There are three noteworthy exceptions we’ll explore here.
Section 530 of the Revenue Act of 1978 provides that an employer may treat a worker as an independent contractor exempt from federal payroll tax laws if they have a reasonable basis for doing so. A reasonable basis would include one or more of the following:
In addition to the above, the employer must have treated all the workers in question and similar workers as independent contractors. The employer also must have issued a 1099-MISC for each of the workers (unless a worker earned less than $600).
If an independent contractor is passed through the common law test, they can still be classified as an employee by statute if they fit any of the four following conditions described by the IRS:
These are direct sellers, licensed real estate agents, and certain companion sitters who are considered contractors rather than employees if they fit the following two conditions:
At this point you might be asking, “Didn’t I hear about a new test for determining contractors?”
If you live in California (or New Jersey, or Massachusetts) you might have heard about the ABC test for determining contractors. The California Supreme Court determined that a worker for a business will be considered an employee unless they fit all three of the following criteria:
Your choice to hire an employee or an independent contractor should be based on your business needs, talent, and culture, among a variety of other factors. But whatever you decide, make sure you know the difference and provide clarity to your team about their status.
While this shift is only happening in California (with similar rules in Massachusetts and New Jersey), given the size of the California economy, the number of contractors in state and the rise of the gig economy, it could have larger repercussions over time. Subscribe to our blog to stay updated on these types of changes!