What Is the Difference Between an Independent Contractor vs Employee?

Feb 02, 2022

Lets face it, the independent contractor vs employee discussion is not going away, it is actually becoming even more important. With COVID you see so many people starting new business ventures which brings this question to the fore front. You also have states really cracking down on this exact topic.

With that being said, lets go through what you need to know when it comes to determining if a worker should be an independent contractor or employee.

What Is An Independent Contractor?

Per the IRS website: 

"The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done."

"You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed."

Professionals who are in an independent trade that offer their services to the general public are typically going to be independent contractors. Think of doctors, lawyers, accountants, trade contractors (plumbers, electricians, roofers, etc.) that have their own practice or business.

What Is An Employee?

Per the IRS website: 

"Anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed."

This is often going to be an individual that does not offer their services to the public but rather works 100% for one company. Think of a plumber or attorney that does work for only one company without offering their service to the general public.

Why Is Independent Contractor vs Employee Such a Big Deal?

Lets face it, in a perfect world, every worker would be an independent contractor. With independent contractors you do not need to withhold any taxes (federal/state withholding, FICA, Unemployment, etc.), pay benefits, or be subject to most labor laws. You simply pay your contractor for the work they perform.

As an independent contractor you are responsible for paying the taxes on the profit (income minus expenses) from the service you are providing.

However, BOTH state and federal agencies are attacking businesses that are incorrectly classifying their workers. They prefer you classify your workers as employees because then you pay unemployment insurance premiums, withhold taxes, and provide workers compensation insurance. Not to mention employees are also protected by state and federal laws that protect worker rights.

This is an area you do not want to try and trick the government on as you could end up paying large back taxes, fines and judgements.

How Do I Determine If A Worker Is An Independent Contractor or Employee?

From the definitions above you will notice that a common theme that really comes down to control. Who controls the relationship? Essentially it comes down to the facts and circumstances of each individual situation, not every business will be the same. The IRS has three general rules to help determine this:

  1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
  2. Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
  3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

To break it down further it looks more like an employee relationship if:

  • You have control over the day-to-day details of the worker (such as specific instructions or monitored by a supervisor/boss).
  • You reimburse worker for expenses incurred or provide tools, equipment, etc. to the worker.
  • You determine the price or rate for the worker.
  • You determine when the how much the worker will be working.
  • You have no independent contractor agreement.
  • The worker operates as an individual (no LLC or company name).
  • The worker only does work for you and no one else and intends to work there indefinitely.
  • You provide benefits or vacation/sick days.

On the flip side it would look more like a contractor if they primarily decide how they are going to work, how much they are going to charge, they work for other companies, they have unreimbursed business expenses, they have a possibility of incurring a loss on the job, they bring their own tools and equipment, or work on a project by project and not indefinitely. 

At the end of the day, in most cases it usually is pretty clear how the worker should be classified and if they are meant to be an employee, you simply have to suck it up and treat them that way. However, if you truly believe they can be treated as a contractor be sure you document your reasons why and do not be afraid to move forward that way.

As part of our Tax Minimization Program, we have a list of questions you should be going through that will really help make this determination easier for you. If you are not a member yet, now may be a good time to sign-up as this is just one of many topics we touch on!

What Is The California "AB 5 Law"?

The "AB 5 Law" is a law passed by California that basically established an ABC test to determine whether California workers should be classified as employees or not. Many states are starting to implement something similar (although not as stringent). Under the ABC test, workers are assumed to be employees unless that worker is:

A: Free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract and in fact, and
B: Performs work that is outside the usual course of the hiring entity's business, and
C: Is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

The "B" part of the test is really the hardest one to overcome. Imagine a law firm that brings on an attorney that has his own practice to help on one specific case of theirs. Technically part B would not be satisfied. Luckily California has provided exemptions and there are currently over 100 which you can find here (Section 2776-2784). 

Independent Contractor vs Employee Wrap Up and Common Mistakes

  • Often times you would rather pay a worker as an independent contractor and they often times would prefer that but ultimately it's not a choice you two get to make, you need to follow both state and federal laws to ensure you are in compliance.
  • Much of the determination between independent contractor vs employee comes down to control, who controls what will be done and how it will be done.
  • If you determine a worker is an independent contractor, great, just be sure to record why and ensure you have a solid basis to stand on.
  • If it looks like an employee, acts like an employee, is paid like an employee, it's probably an employee and just bite the bullet.
  • Just because your friend who is a business owner does it one way doesn't mean that it is correct or that you can treat it the same way. Every situation and circumstance is different.
  • Do not think you will be able to simply "fly under the radar". At some point it will catch up to you and has the potential to put you out of business with back taxes, penalties, fines, etc.

Now that this information and analyze your current workers to see if anything needs to change or take it into consideration for your next hire.

 

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