Independent Contractor versus Employee – How to Classify

It is additional work and more expensive to maintain a staff of employees compared to hiring independent contractors.   But there are strict rules on determining a workers status.  The courts analyze 7 factors to determine the classification of workers.  The 7 factors are used to determine the degree of control and independence.

Who Has Control, Business or Worker?
If the business has significant control of the workers then the workers should be treated as employees.  If the business has no control of the workers then the workers should be treated as independent contractors.

For example, a local hardware store hires a worker to be a cashier.  The business determines the pay rates, working hours and how the job is done.  The worker can be fired at any time for not performing his or her duties.  This worker is classified as an employee because the business has complete control of the worker.

Conversely, a local hardware store hires a worker to remodel the break room.  The business entered into a contract with the worker for the remodeling job.  The contract defined the cost of the job, scope of work and completion date.  The business does not determine how the work is done.   The worker does not have set working hours but the job must be completed by the agreed upon date.  The business can’t fire the worker as there is a contract in place.  The worker is classified as an independent contractor because the business a low degree of control.

7 Factors, Who has control?
It is easy to classify workers if they fall in either end of the spectrum: full control versus limited to no control.  But what if the workers fall somewhere in the middle.  Perhaps, the business wants to hire only independent contractors.  The business should understand what to do or not do to insure that the workers are classified properly.

The courts apply 7 factors to determine a workers classification, employees or independent contractors.  None of these factors alone can be used to correctly determine the workers classification.  After reviewing your situation, some of the factors may favor employee classification while other factors favor independent contractor classification.  All the factors are analyzed as a whole to determine the proper treatment of the workers.

Factor 1: The degree of control the business has over the worker
Does the business control the working hours, total hours, pay rates, pay period, office location, quality of work, monitor how work is done and other control factors?  A business has employees if the business has sufficient control.

This factor is based on the right the business has to exercise control over the worker regardless if the business chooses to use that right.  For example, a business may not set all the hours a worker must work but the business could if it wanted too.

Factor 2: Which party invests in work facilities used by the worker
Does the business provide the office space or does the worker have his or her own office?  Who supplies all the equipment used by the worker?

For example, the worker may use their own small tools to perform most of their work.  But the business provides the office space and heavy equipment.  This example would favor employee status.

Factor 3:  The opportunity of the worker to realize a profit or loss
Does the worker get paid a flat fee or salary?  If the worker is paid hourly, does the business limit the working hours?  Yes to these two questions would favor employee status.

Is it possible for the worker to incur a loss?  Does the worker have the ability to increase their earnings through their efforts?  Yes to these two questions would favor independent contractor status.

Factor 4: Can the business discharge the worker
Does the business have the right to fire the worker at any time?  This would favor employee status.  If there is a contract in place making it difficult for the business to fire the worker, it would favor independent contractor status.

Factor 5:  Is the work part of the regular business
The company is in the business of fixing computers.  The company hires workers to fix the computers.  The status of these workers favors employee status because fixing computers is part of the regular business.  The same company hires workers to create a website for the company.  These workers would likely favor independent contractor status because creating websites is not part of the regular business.

Factor 6:  The permanency of relationship
Are the workers hired to work for the business long term?  This would favor employee status.  Are the workers hired temporarily and are the workers free to find work elsewhere?  This would favor independent contractor status.

Factor 7:  The relationship the business thought they created with workers
Did the business purchase workers compensation or employer’s liability insurance?  Did the business cover the job-related expenses?  Did the business provide benefits such as health insurance, life insurance, and retirement plans?  Did the workers believe they were employees?  Yes to all these questions would favor employee status.

It is critical to determine the proper status of the workers hired.   The costs for improperly classifying employees are significant.  If the IRS audits your business and determines that workers are misclassified, your business will be responsible for back payroll tax, failure to file penalties, failure to pay penalties, failure to deposit penalties and interest.  Read this blog on more details on the penalties.

If you are still unsure how to classify your employees, file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Withholding, with the IRS.  The IRS will review your circumstances and make a determination.

If you believe you have misclassified your workers, our next blog will review the IRS Relief Provisions and Voluntary Classification Settlement Program (VCSP).

Reviewing worker classification can be complicated.  If you need assistance on determining worker classification, call ALG Tax Solutions 855-MI-Tax-Help (855-648-2943), provide your contact information online, or click Ask Your Question.

IRS Circular 230 Disclosure: To the extent this writing contains advice on a federal tax issue, the advice is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed in this communication.