Ever wonder whether a new hire should be an employee or independent contractor? Here are the basic differences between the two and the guidelines to help determine worker status.

The two most common types of workers are independent contractors and common-law employees.

Hiring an independent contractor often means preparing one IRS and possibly a state form at the end of the year and paying an agreed-upon rate or amount per project. Hiring an employee generally involves withholding and paying taxes, meeting employment standards and common practices and filing reports for multiple government agencies. Federal and state laws governing benefit-plan participation, wage payment, working conditions and workers’ compensation apply only to employees.

Degree of control and independence is the determining factor when deciding whether a worker hired to perform services is an employee or an independent contractor. In order to determine this, facts are organized into three categories: behavioral control, financial control and relationship type. Providing evidence to support the facts is essential in justifying the treatment of a worker as either an employee or independent contractor.

Behavioral control

Behavioral control includes factors that indicate if the business has the right to control how the worker performs tasks, or just controls the outcome. Key factors in this category are instructions and training the business gives the worker.

Employees are generally instructed on when, where and how to work. Instructions given in an employer-employee relationship may include which tools or equipment to use, where to purchase supplies, the order or sequence to follow and who will assist with the work. An employer can control the means and methods an employee uses.

In comparison, the payer of an independent contractor has less control over the means and merely the right to control the result of the work done.

Financial control

Financial control factors determine if the business has the right to control the financial aspects of the job.

Key considerations include the amount of unreimbursed expenses, who decides what equipment will be purchased, how much can be spent on supplies, and if the same services are provided in the market to other businesses. Independent contractors usually have a significant investment in the “facilities or tools” used to perform services and work for multiple businesses. While employees are generally paid by the hour, week or month, independent contractors may be paid by the job. The extent to which the worker can realize a profit or loss is a key indication of the type of worker. Independent contractors can incur a profit or loss on the work they perform since they control their financial outcome.

Type of relationship

Type of relationship examines whether written contracts describe relationships between the parties and if the business provides the worker with benefits usually reserved for employees.

An employee-type relationship would include benefits such as health insurance, a retirement plan, sick and vacation pay, continuing education and training. If the relationship is expected to continue indefinitely with the worker, rather than on a per-project basis, this is generally intended as an employee-employer relationship.

Another indicator is the extent the worker’s services are a key aspect of the business. If the services are essential, the worker is more likely to be considered an employee whose work is directed by the company. If an employer-employee relationship exists, the employer is obligated to deduct federal income tax withholding, to deduct and “match” Social Security and Medicare taxes and to pay federal unemployment tax. There may be additional state income tax to withhold, in addition to state unemployment compensation contributions and state disability insurance. Since a business is not normally required to withhold taxes from payments to independent contractors, the IRS favors employee status.

Statutory employees

Some workers, such as salespeople, may not meet the tests for common-law employees, but meet the tests to qualify as a statutory employee. Statutory employees are not required to have federal income tax withheld from pay, but their pay may still be subject to Social Security, Medicare and FUTA taxes. There are eight elements of the statutory employee test, which can be found in IRS Publication 15-A.

If an employee is incorrectly classified as an independent contractor, the employer can be held liable for employment taxes for that worker, plus a penalty and interest — although there are safe harbor provisions that an employer can avail itself of if corrected before the IRS notifies them of the issue. The IRS will determine, if requested, whether or not a worker is an employee upon the filing of Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. If the IRS is asked to make the determination, the conclusion is binding.

Establishing a worker’s correct status before the time of hire will avoid costly adjustments down the road.

Lydia Ahn is an accountant with Varner Sytsma Herndon, CPAs. She can be reached at (360) 734-8715 or Ahn@vshcpa.com