Businesses grow, and that’s a great thing, but if they grow wrong, they can face additional costs along the way. One of these areas you must grow correctly is with your new hires. There are many reasons you’d want to hire an independent contractor over an employee or vice versa when just starting out, but taxes are the primary reason and the one we’ll examine in this article.
Fortunately, the IRS published guidelines for how to determine whether your hire is an employee or an independent contractor. I will give a summary of this analysis, but if the question is too close to call, you may want to consult an attorney or IRS Form SS-8.
There are three factors the IRS looks to in order to determine the degree of control and independence that makes up the decision of whether a person is an independent contractor or an employee. The IRS will weigh all three factors together to determine the status of a worker.
The IRS asks “does the company control or have the right to control what the worker does and how the worker does his or her job?”
Put simply, how much guidance is there on how the job gets done. You can hire someone to simply “take photos of any dog,” and this person would easily be an independent contractor under this factor. However, you can hire a person to take photos of various wildlife at your zoo whenever you choose to have the photos taken, and you have the creative direction to choose how the photos are taken, that person will likely be an employee. In these scenarios, there’s a huge difference who is controlling the operation. It should also be noted that being able to refuse to accept a photo because of quality is different than choosing how the photo will be taken before it gets taken.
As with all three factors, this is a spectrum analysis. There’s no bright line that determines whether or not a person is an employee or independent contractor. You will have to take this factor into account with the other two and determine if it is more likely an employee or not.
Here are some things you can do in order to make your hire more like an independent contractor than an employee:
- Guidelines on outcome, not how to get there.
- No instructions on what equipment to use unless it makes a difference in the outcome.
- No instructions on who to hire.
- No instructions on where to purchase supplies/services.
- Don’t provide training. Training implies an employee relationship and an ongoing one.
Short IRS Description: “Are the business aspects of the worker’s job controlled by the payer?”
This factor is a numbers game, but without any fixed amounts to make the determination. The IRS will look to whether, because of financial contributions and control, the hire appears to be an employee or an independent contractor. There are several very noticeable differences between employee-employer relationships versus that of an independent contractor. For example, a photographer who is an employee will use the camera supplied by the company rather than use his or her own. Likewise, independent contractors are not reimbursed for numerous expenses, unlike an employee who would have to pay out of pocket.
Some factors the IRS looks to:
- Significant Investment: Like the own camera example, if the tools provided are owned by the hire, they’re more likely an independent contractor.
- Unreimbursed Expenses: Employees are more likely to be reimbursed.
- Opportunity for profit or loss: Instead of a fixed hourly wage, if there’s an opportunity to make more or make less because of financial decisions, the worker is more likely an independent contractor. An employee will never face the opportunity to make a loss.
- Services Available to the Market: Employees can be restricted from working in the general market, but independent contractors must be allowed to advertise, maintain a visible business location and take on other clients.
- Method of Payment: Guaranteed payment over salary or hourly wage makes a case for employee, but flat fee per job is more likely an independent contractor.
- Bid versus Application: This isn’t typically referenced, but if the job is chosen in a bidding process, it is highly probable that the hire is an independent contractor.
Type of Relationship
Briefly stated: “Are there written contracts or employee type benefits? Will the relationship continue and is the work performed a key aspect of the business?”
This is the smell test for the IRS. They will look to the contract, the nature of the business relationship and subjective features that cannot be measured in the other two factors. It’s very important to know, and remember, that what the contract says to this extent has no baring on the IRS’s determination. If the contract says the hire is an independent contractor, yet fits clearly into the definition of an employee, the IRS will determine that hire is an employee and will treat him or her as such for tax purposes.
Some key things to look at:
- Employee benefits are only for employees. You cannot offer insurance, pension plans, paid vacation, sick days, etc to an independent contractor. It’s just not possible, so any inclusion of these things in an agreement makes the person an employee, if they’re validly included.
- Permanency of the Relationship. If you hire a worker expecting an indefinite relationship rather than a per-job relationship, you’re looking at an employee. To better position yourself to hire an independent contractor, make clear in the contract and in the relationship that this is a hire specifically for one job. You can always renegotiate another contract for the next job.
- Services Provided as Key Activity of the Business. The IRS likes to use attorneys as an example, but this doesn’t work well anymore. Instead, we’ll use the example of a grocery store that hires someone to cashier. Since making sales is a key activity of the business, it is more likely that person is an employee. This piece of the determination is not very weighted because of the nature of business now. It is actually quite common for bartenders to be independent contractors at a bar, or doctors at a hospital for that matter. The core functions of your business can be separated and contracted out, but it must be done properly.
The prime reason people want to avoid hiring employees is to avoid the FICA (social security) taxes and unemployment insurances. If you have one employee, you must keep withholdings from your employee’s check, pay into FICA, and pay into unemployment insurance. There are also state specific programs and taxes you will have to pay into as well. With independent contractors, you merely send them their pay and report their pay on a 1099. It may be easier and more cost effective to hire only independent contractors, but that’s not always the case. Many jobs require employees and some employees can add much more value to a company than any independent contractor could. The right employee can make those extra costs and work seem worth it.
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