Employee vs. Independent Contractor Status

Drew Blaney, Tax Senior Manager
October 2015

Employers often must decipher how to treat payments made to workers for their services.  Determining whether the payment represents wages or contracted services involves making a distinction of whether someone should be treated as an employee or independent contractor.  Employers generally must withhold income taxes, withhold and pay employees’ shares of social security and Medicare taxes, match those payments with the employer’s own funds, and pay unemployment taxes on all wages paid to their employees.  Also, employees, but not contractors, must be included in various retirement, health and other benefit plans.  Payments made to independent contractors, on the other hand, may only require that an information return be filed with the IRS at year end; there generally is no requirement to withhold and remit income or payroll taxes on those payments.  Rooted in these differences are significant motivations for payers to prefer independent contractor treatment and for the IRS and Department of Labor to prefer employee treatment.  Suffice to say, proper classification of an individual’s employment status is very important.

Determining whether the recipient is an employee or independent contractor is based on common-law rules.  An individual is considered an employee if the payer has the right to control the details of how, when, and where the work will be done.  In contrast, an independent contractor generally may apply his or her own methods to complete the work.  Note that in both instances the payer retains control of the work product and end result, but the methods used to accomplish the work depends on the employment status of the hired individual.

Below are three main categories that the IRS considers when determining whether the recipient of payment more closely resembles an employee or independent contractor.1

  1. Behavioral Control – facts and circumstances relating to the degree of control the payer retains with respect to how the designated task is completed.
    1. Instructions – if a worker is given specific instructions for the job, it may indicate an employer-employee relationship.  Examples include:
      1. How, when, and where to do the work.
      2. What tools or equipment to use.
      3. What workers to hire or to assist with the work.
      4. Where to purchase supplies and services.
      5. What work must be performed by a specified individual.
      6. What order or sequence to follow.
    2. Training – if a worker is given a particular training to perform his/her duties, it may indicate an employer-employee relationship.
  2. Financial Control – facts and circumstances relating to the degree of control the payer retains with respect to monetary aspects of the job’s completion.  Examples include:
    1. The extent to which the worker has unreimbursed business expenses.  Independent contractors are less likely to be reimbursed for their expenses.
    2. The extent of the worker’s investment.  Independent contractors typically have significant investments in their facilities and tools.
    3. The extent to which the worker makes his or her services available to the relevant market.  Independent contractors typically advertise their services and are readily available to the general market.
    4. How the business pays the worker.  Independent contractors are often paid a fee for the job completion whereas employees are generally paid on a recurring basis.
    5. The extent to which the worker can realize a profit or loss.  Independent contractors can realize (incur) a profit (loss) on their work.
  3. Relationship of the Parties – facts and circumstances relating to the nature of the parties’ relationship.  Examples include:
    1. Written contracts describing the relationship the parties intended to create.
    2. Whether or not the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay.
    3. The permanency of the relationship. Independent contractors are generally only hired for a specific project and are not considered to be hired indefinitely.
    4. The extent to which services performed by the worker are a key aspect of the regular business of the company.

Conclusion
Taxpayers should be aware that this area is carefully scrutinized by the IRS and is the subject of many tax related court cases.  If the IRS determines that a payment recipient that was treated as an independent contractor should have been instead treated as an employee, it usually will assess employment taxes on the “employer.”  It is important to consider all of the facts and circumstances when documenting your position on an individual’s employment status – no single fact can be solely relied upon.  Ultimately, the key element for making an employee v. independent contractor determination hinges on whether or not the employer has the right to control how the services are performed.  Taxpayers should consider consulting their tax advisors for a more thorough discussion on the classification of an individual’s employment status.

If you would like to discuss further, please contact Drew Blaney or your BNN tax advisor at 1.800.244.7444.

[1] Information summarized from IRS Publication 15-A (2015).


Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.