As businesses grow, staffing needs increase. Should an organization hire an employee or independent contractor?
To answer this question on small business compliance, we’ve created a three-part blog series on classifying employees. First, we’ll look at how to apply the common law test to avoid negative tax consequences.
There are important distinctions between an employee and an independent contractor, and misclassifying an employee as a contractor can result in significant tax penalties. To add an employee, the business must withhold income, Social Security, Medicare, and state taxes, in addition to matching the Social Security and Medicare taxes, and paying federal and state unemployment taxes. These aren’t required to employ independent contractors.
The primary consideration for determining if a worker is an employee or an independent contractor is the common law test.
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.
Example | Let’s look at how an employee vs. an independent contractor would replace a window:
Employee: The individual is provided ongoing training on how to replace types of windows, and he or she receives detailed instructions about when, where, and how to work. Employees are provided the necessary tools, reimbursed for any expenses incurred, and are paid by the hour, week, or month. Employees also receive benefits and maintain an ongoing relationship with the employer.
Independent Contractor: The individual is told to replace a window, but how the contractor approaches the job is up to them. Any payment received for the work performed is all-inclusive, meaning contractors won’t be reimbursed for their expenses. Also, contractors maintain their own tools and equipment, and they typically complete similar services for other clients daily.
Deep Dive: Check out Social Security’s course on how to apply the common law test for a list of frequently asked questions and answers.
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.
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).
There are certain workers who will always be classified as employees, including full time life insurance agents, and food truck (except for milk) drivers. This IRS article discusses those exceptions.
These are direct sellers, licensed real estate agents, and certain companion sitters. This IRS article provides more information on statutory nonemployees.