Employee or Independent Contractor?

by Annette Zinky and Sarah Hoel (November 2007)

Small business owners are continuously in search of ways to save money.  Many times clients come into the Small Business Development Center and ask, “Wouldn’t it be cheaper for me to hire independent contractors instead of employees?”  While it is true that a business does not pay overtime, unemployment tax, matching FICA taxes, or withhold the employee’s portion of taxes from an independent contractor’s wages, the roles of independent contractors and employees are not frequently interchangeable.  You would be better off making the correct determination in the first place, rather than being subject to penalties for improper classification of a worker.  In most cases, this is not nearly so much of a gray area as some may think.  There are some general guidelines that may lead you to the answer quickly.  The 3 main factors that determine a worker’s status are:  behavioral control, financial control, and relationship of the parties.  Taken all together, they can determine whether that worker is an employee or an independent contractor.

1. Behavioral Control – This refers primarily to training and instructions.  The main question to examine here is, “Who determines how, when & where to do the work, what tools to use, whom to employ, or where to purchase supplies?”  A general rule for businesses is that if you can control both what will be done and how it is performed, then the worker is an employee.  There are a few instances when there is no clear behavioral control and the worker is classified as an employee by federal statute.  Some examples of these employees are delivery drivers, insurance agents, full-time traveling salespeople, or at-home workers whose materials & specifications are furnished by the company to which the product will be sold.

2. Financial Control – This covers the business aspect of the work.  For example, does the worker have a significant investment in the work?  Are all or part of the worker’s business expenses reimbursed by the company?  Does the worker take the risk of profit & loss?  How is the worker paid?  Does the worker make the same services available to other parties?  Generally speaking, if a worker has not invested his or her own money at risk in the job, he or she is probably an employee.

3. Relationship – This involves written contracts, benefits offered, the duration of the relationship, and how important the services are to the primary function of the business.  The most obvious test of this is whether the worker offers his or her goods or services to you exclusively, or to other businesses at the same time.

Through decades of court findings across the country, a “Common Law Test” has been established to help judges (and employers) make a determination that you, your workers, and the IRS can live with.

For those who find it too difficult to determine on their own, the IRS can determine that for you if you fill out and submit their SS-8 form.  There is no charge for the IRS to make a worker status determination for you or your worker.  The IRS will contact both the company and the worker to gather as much information as possible to make that determination. Using the IRS should be a last resort because businesses can typically figure this out themselves or they turn to an SBDC counselor to help sort out the details.

Overall, knowing whether someone that works for you is regarded as an employee or an independent contractor is important.  The answer establishes your legal responsibility to pay and withhold Federal income tax, social security, Medicare taxes, and Federal Unemployment tax.

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