Businesses have the option of paying a worker as a regular employee through Form W-2 (Wage and Tax Statement) or an independent contractor through Form 1099 NEC (Non-Employee Compensation). There are rules regarding each option and possible legal repercussions for inaccurately treating an employee as an independent contractor. Below, I discuss how the IRS considers the issue.
Independent Contractors Versus Employees
An independent contractor is a worker who individually contracts with an employer to provide specialized or requested services on an as-needed or project basis rather than ongoing. In general, independent contractors have greater control over the way they carry out their work than employees.
Employers assume fewer duties with respect to independent contractors, who are generally outside the coverage of various laws that apply to the employer-employee relationship, such as tax withholding. The penalties for misclassifying a worker can include back taxes or premiums, civil fines, interest and other retroactive charges.
Essential Determinant: Degree of Control
The IRS classifies evidence of the degree of control that distinguishes an employee from an independent contractor into three categories:
1. Behavioral Factors – Does the company control or have the right to control what the worker does and how the worker does his or her job?
This includes instructions about how to do the work – when and where, what tools to use, where to purchase supplies and services and what order or sequence to follow in doing the work. Also, the more detailed the instructions the worker is given, the more control the business exercises.
Training on how to do the job is strong evidence that the worker is an employee. Finally, if an evaluation system measures the details of how the work is performed, that would also suggest an employee.
2. Financial Factors – Are the business aspects of the worker’s job controlled by the payer?
An independent contractor often has a significant investment in the work equipment used and may have unreimbursed expenses, though those may also be true for employees. The possibility of incurring a loss, such as their expenses exceeding their income from the work, suggests the worker is an independent contractor. An independent contractor is generally free to seek out other business opportunities in the relevant market.
An independent contractor is usually paid by a flat fee for the job, while an employee is generally guaranteed a regular wage amount for an hourly, weekly or other period of time
3. Relationship – Are there written contracts or employee benefits?
Employee benefits include insurance, pension plans, paid vacation, sick days and disability insurance. Businesses generally do not grant these benefits to independent contractors.
If you hire a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.
If a worker provides services that are a key aspect of the business – such as a law firm hiring a lawyer — it is more likely that the business controls his or her activities and is thus an employee.
Burden of Proof
Businesses must weigh all the above factors when determining whether a worker is an employee or independent contractor. The IRS presumes that a worker is an employee unless proven otherwise. So, the burden of proof is on the employer to show that it has classified a worker correctly.
Employers and workers can file Form SS-8 (Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding) to get a determination from the IRS as to whether or not a worker is an independent contractor. A business that continually hires the same types of workers may want to consider filing it.
Department of Labor Classification
To complicate matters, the Department of Labor uses a different classification system to determine worker status for purposes of wage and hour laws, including minimum wages, overtime and child labor laws. So, a worker may be classified as an independent contractor under one system and as an employee under another.
Business Entities
Some groups of professional workers, such physicians and other licensed health professional often create their own business entities, often limited liability companies (“LLC”), or professional service corporations (“PA”). Since a business entity in the US can never be classified as an employee, contracting with business entity is one way in which an employer knows that the individual actually providing the services does not have to be treated as an employee.
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