I insure a number of contractors and businesses that claim that they don’t have any employees.  They say that anyone that performs work for them is an independent contractor and they report what they pay them at the end of the year on the federal form 1099 for independent contractors. 

Now I know why businesses prefer to pay people as independent contractors because it can be costly to hire someone as an employee.  When you have employees you are subject to pay employment taxes (13.85% above the workers wages earned owed to the government), workers compensation insurance, and NYS statutory short-term disability insurance.  Some businesses hear all of these additional expenses associated with hiring an employee and are quick to classify anyone that performs work for them as an independent contractor. 

Independent contractors are responsible to pay their own self-employment taxes on their annual tax return and carry their own business and disability insurance. 

Most businesses would be in for a rude awakening if they are audited by the IRS.  The IRS may decide to classify that independent contractor as an employee.  If the IRS changes your business’ classification of an independent contractor to an employee you can face stiff penalties and owe back taxes. 

Even if you have a contract that states that the worker is an independent contractor, this is not sufficient to determine the worker’s status.  The IRS is not required to follow a contract stating that the worker is an independent contractor.  How the parties work together determines whether the worker is an employee or an independent contractor. 

There are three characteristics used by the IRS to determine the relationship between businesses and workers:

1. Behavioral control – covers the facts that show whether the business has a right to control how the work is done through instructions, training, or other means.
2. Financial control – covers the facts that show whether the business has a right to direct or control the financial and business aspects of the worker’s job.
3. Type of relationship – relates to how the workers and the business owner perceive their relationship

Behavioral control refers to facts that show whether there is a right to direct or control how the worker does the work.  An employee is generally subject to the business’s instructions about when, where, and how to work.  All of the following are examples of types of instructions about how to do work:

• When and where to do the work
• What tools or equipment to use
• What workers to hire or assist with the work
• Where to purchase supplies and services
• What work must be performed by a specified individual 
• What order or sequence to follow when performing the work

Financial control refers to facts that show whether or not the business has the right to control the economic aspects of the worker’s job.  The financial control factors fall into the categories of:

• Significant investment – an independent contractor often has a significant investment in the equipment he uses in working for someone else.
• Unreimbursed expenses – independent contractors are more likely to have unreimbursed expenses than are employees.
• Opportunity for Profit or loss – having the possibility of incurring a loss indicates that the worker is an independent contractor.
• Services available to the market – an independent contractor is generally free to seek out business opportunities.
• Method of payment – an employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time.  An independent contractor is usually paid by a flat fee for the job.

Type of relationship refers to facts that show how the worker and business perceive their relationship to each other.  The factors for the type of relationship between two parties generally fall in the categories of:

• Written contracts
• Employee benefits
• Permanency of relationship – if you hire a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.
• Services provided as key activity of the business – for example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work.  This would indicate an employer-employee relationship. 

If after reading this summary of employee vs. independent contractor that I summarized from the IRS.gov website, you still aren’t sure how to classify your worker, you can ask for the governments help.  You can file form SS-8 – “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding”.  This way you can be sure that you won’t be surprised by an IRS audit that changes your classification of independent contractor to employee.

This entry was posted on Monday, September 14th, 2009 at 8:42 am and is filed under Business Insurance. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.