Employee? Or Independent Contractor?

In the current business environment, employers have found an increasing need to hire workers for short-term projects or workers with specific unique skills. Determining whether these individuals should be classified as employees or as independent contractors can be difficult.

Companies that fail to properly classify their workers could face significant cost increases for additional taxes, penalties, and interest. The characteristics that differentiate an employee from an independent contractor typically revolve around the relationship between the worker and the company, and the level of control each one has. The determination of worker classification depends on multiple factors, which fall into three general categories.

Behavioral Control

These factors refer to whether an employer has a right to direct or control how a worker performs services. This includes the type and degree of instruction, the evaluation process, and training. An independent contractor is expected to have the required skills, discretion over methods used to obtain results, and the ability to manage their own schedule. In an employer-employee relationship, the company usually provides training in order to accomplish the desired results. The employee follows the employer's guidelines as directed, as well as the work schedule outlined by the employer.

Financial Control

An independent contractor maintains the risk of making a profit or incurring a loss from the services provided, while an employee does not. An independent contractor usually incurs unreimbursed business expenses and may have a separate place of business and/or own business assets, such as office equipment. Employees are typically reimbursed for out-of-pocket business expenses, and will normally use the employer's facilities and equipment to perform their duties. Employees are generally paid a wage based on an hourly rate or salary. An independent contractor is typically paid a flat fee or may be paid on an hourly basis.

Type of Relationship

The employee vs. independent contractor determination is also dependent upon how the company and individual perceive their relationship. Generally, employees are entitled to employer-paid benefits, such as insurance. Independent contractors are not entitled to these benefits. Employees are hired on a permanent basis while independent contractors are not. However, the mere fact that a worker is temporary or is paid hourly is not conclusive.

The IRS is more likely to classify a worker as an employee if he/she provides services that are a key aspect of the business. The Illinois Department of Employment Security has an even more narrow definition of an independent contractor. Their default position is that every worker is an employee unless all of the following three criteria are met:

A) The individual is free of control or direction over performance of services.

B) The service provided is performed outside the usual course of business of the employer.

C) The individual is engaged in an independently established trade, occupation, or profession.

It is the responsibility of the company to evaluate its relationships with workers and to determine proper classifications and be prepared to support them if audited by the IRS or IDES. Adequate support includes, but is not limited to, having a written contact with the worker and issuing a timely filed Form 1099 to the independent contractor. Workers with their own company serving multiple clients are more likely to be considered independent contractors than workers with single clients.

Conclusion

Using independent contractors can be a cost-effective way of operating without the additional costs incurred with employees. However, the cost of misclassifying employees often far exceeds the cost of proper compliance. The classification rules can be complicated and difficult to navigate. If you have any questions concerning worker classification, please consult your tax adviser.

* Judy Mason, CPA, CVA, is a partner with Michael Silver & Company CPAs in Skokie. Other contributors from the firm include Janell Wilson, CPA, audit manager, and Roxanne Edralin, CPA, staff accountant.