Independent Contractor -
Which Is It?
If you hire someone for a long-term, full-time project or a
series of projects that are likely to last for an extended
period, you must pay special attention to the difference
between independent contractors and employees.
Why It Matters
The Internal Revenue Service and state regulators scrutinize
the distinction between employees and independent contractors
because many business owners try to categorize as many of
their workers as possible as independent contractors rather
than as employees.
They do this because independent
contractors are not covered by unemployment and workers'
compensation, or by federal and state wage, hour,
anti-discrimination, and labor laws. In addition, businesses
do not have to pay federal payroll taxes on amounts paid to
Caution: If you incorrectly classify an employee as an
independent contractor, you can be held liable for employment
taxes for that worker, plus a penalty.
The Difference Between Employees and Independent Contractors
Independent Contractors are individuals who contract with a
business to perform a specific project or set of projects.
You, the payer, have the right to control or direct only the
result of the work done by an independent contractor, and not
the means and methods of accomplishing the result.
Sam Smith, an electrician, submitted a job estimate to a
housing complex for electrical work at $16 per hour for
400 hours. He is to receive $1,280 every 2 weeks for the
next 10 weeks. This is not considered payment by the
hour. Even if he works more or less than 400 hours to
complete the work, Sam will receive $6,400. He also
performs additional electrical installations under
contracts with other companies that he obtained through
advertisements. Sam Smith is an independent
Employees provide work in an
ongoing, structured basis. In general, anyone who performs
services for you is your employee if you can control what will
be done and how it will be done.
A worker is still considered an employee even when you give
them freedom of action. What matters is that you have the
right to control the details of how the services
Sally Jones is a salesperson employed on a full-time
basis by Rob Robinson, an auto dealer. She works 6
days a week, and is on duty in Rob's showroom on certain
assigned days and times. She appraises trade-ins,
but her appraisals are subject to the sales manager's
approval. Lists of prospective customers belong to the
dealer. She has to develop leads and report results to
the sales manager. Because of her experience, she
requires only minimal assistance in closing and
financing sales and in other phases of her work. She is
paid a commission and is eligible for prizes and bonuses
offered by Rob. Rob also pays the cost of health
insurance and group term life insurance for Sally.
Sally Jones is an employee of Rob Robinson.
The IRS, workers' compensation boards, unemployment
compensation boards, federal agencies, and even courts all
have slightly different definitions of what an independent
contractor is, though their means of categorizing workers as
independent contractors are similar.
One of the most prevalent approaches used to categorize a
worker as either an employee or independent contractor is the
analysis created by the IRS. The IRS considers the
1) What instructions the employer gives
the worker about when, where, and how to work. The more
specific the instructions and the more control exercised, the
more likely the worker will be considered an employee.
2) What training the employer
gives the worker. Independent contractors generally do not
receive training from an employer.
3) The extent to which the worker has business expenses that
are not reimbursed. Independent contractors are more likely to
have unreimbursed expenses.
4) The extent of the worker's
investment in the worker's own business. Independent
contractors typically invest their own money in equipment or
5) The extent to which the worker makes services available to
other employers. Independent contractors are more likely to
make their services available to other employers.
6) How the business pays the
worker. An employee is generally paid by the hour, week, or
month. An independent contractor is usually paid by the job.
7) The extent to which the worker can make a profit or incur a
loss. An independent contractor can make a profit or loss, but
an employee does not.
8) Whether there are written
contracts describing the relationship the parties intended to
create. Independent contractors generally sign written
contracts stating that they are independent contractors and
setting forth the terms of their employment.
9) Whether the business provides the worker with employee
benefits, such as insurance, a pension plan, vacation pay, or
sick pay. Independent contractors generally do not get
10) The terms of the working
relationship. An employee generally is employed at will
(meaning the relationship can be terminated by either party at
any time). An independent contractor is usually hired for a
11) Whether the worker's services are a key aspect of the
company's regular business. If the services are necessary for
regular business activity, it is more likely that the employer
has the right to direct and control the worker's activities.
The more control an employer exerts over a worker, the more
likely it is that the worker will be considered an employee.
Minimize the Risk of
If you misclassify an employee as an independent contractor,
you may end up before a state taxing authority or the IRS.
Sometimes the issue comes up when a terminated worker files
for unemployment benefits and it's unclear whether the worker
was an independent contractor or employee. The filing can
trigger state or federal investigations that can cost many
thousands of dollars to defend, even if you successfully fight
There are ways to reduce the risk of an investigation or
challenge by a state or federal authority. At a minimum,
- Familiarize yourself with the rules.
Ignorance of the rules is not a legitimate defense. Knowledge
of the rules will allow you to structure and carefully manage
your relationships with your workers to minimize risk.
- Document relationships with your workers and vendors.
Although it won't always save you, it helps to have a written
contract stating the terms of employment.
If you have any questions about how to classify your
employees, please give me a call at 301-657-8080. We
can help guide you in the right direction in the eyes of the
this article online,
click here or go to
www.eSullivan.net and click on the Newsletter section.
As always you can call our offices if you have any
questions about these or any other accounting, tax,
financial planning or insurance related issues, at 301-657-8080.
Regards, Paul Sullivan, CPA
President, Sullivan & Company