Employee vs. Independent Contractor – Seven Tips for Business Owners
Businesses, small and large, have always struggled with hiring demands. For the typical establishment, payroll and the associated tax burden is by far the largest expense. According to the Center for Entrepreneurship at Belmont University in Nashville, employee salaries and wages can account for as much as 80 percent of a small company’s total expenses. From an employer’s perspective then, it makes a lot of sense to do whatever it takes to bring this massive expenditure of precious financial resources under some semblance of control, without sacrificing the quality of work performed and the morale of employees. Effective payroll tax mitigation strategies are key. Most small employers would be loath to trim employee salaries without good reason, but they certainly wouldn’t mind trimming some of Uncle Sam’s take. Smart tax management can be a solution to the problem of ballooning payroll costs. Attempting to exploit perceived loopholes, however, is not.
One particular area where businesses can reduce payroll tax liability is by “employing” independent contractors, or 1099 employees, as an alternative to hiring W2 employees who carry an employer tax burden. Using independent contractors is especially common for businesses that have spikes in labor demands or project based work – a logical means to control expenses. However, some businesses have recognized this tax advantage and have misused this in their hiring practices. As a result, the IRS has defined standards which govern the appropriation of independent contractor and employee designations.
In other words, there are rules to how businesses can classify the people they hire. Over the last few years, improper classification violations have surfaced in audits and lawsuits against many employers. In a substantial number of those cases, the penalties for non-compliance have cost employers far more than any potential tax savings.
As mandated under the Fair Labor Standards Act, following are seven things every business owner should know about bringing people on as independent contractors versus hiring them as employees.
- The Internal Revenue Service (IRS) categorizes employer-employee relationships using three primary characteristics: Behavioral Control, Financial Control, and Type of Relationship factor. Together, these are often referred to as common law rules and act as a guide for properly designating employees.Behavioral Control means exactly that – an employer has the right to control how a worker does the work. The business retains the right to determine when, where, and how work is to be performed by an employee.Financial Control exists when a company retains the right to control the business aspects of a worker’s activities. In other words, they control the results of work, but not how it is done.Type of Relationship describes the intended relationship between an employer and workers. Typically, this is in the form of a written contract.
- If a business has direct control over the actions of their employees, including both what tasks are to be done and in what manner, their workers are most likely employees.
- If a business only exerts direct control over the result of the work done, and not the means and methods of accomplishing that result, then their workers can most likely be considered contract workers.
- Do not be tempted to misclassify employees as independent contractors. Those who do are essentially breaking the law, and can face substantial tax bills as well as financial penalties for failing to pay employment taxes and submitting the required tax paperwork.
- As for workers, higher tax bills and a loss of benefits can be avoided by simply knowing their appropriate designations.
- For clarification purposes, both employers and their workers can request a ruling from the IRS to determine whether a specific individual is an employee or a contractor. To do so, file a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS.
- If the status of an employer’s workers is still unclear, more information can be found at the IRS website, in Publication 15-A, Employer’s Supplemental Tax Guide, Publication 1779, Independent Contractor or Employee, and Publication 1976, Do You Qualify for Relief under Section 530? These publications and Form SS-8 are available on the IRS website or by calling the IRS at 800-829-3676 (800-TAX-FORM).
The obligation to withhold and pay payroll taxes applies to businesses with workers classified as employees. Those with workers classified as independent contractors do not generally bear responsibility for payroll tax obligations. As a result, some businesses aiming to cut payroll costs, whether knowingly or unknowingly, fall into the trap of incorrectly classifying their workers.
This is a big mistake.
Misclassification of workers is a big red flag for the IRS, and for the courts. Some employers misconstrue the worker classification system as an opportunity to avoid incurring payroll tax obligations simply by having their employees declared independent contractors. These unscrupulous agreements do not stand up to the aforementioned common-law rules, and as a result, invite federal audits and potential litigation. Remember, if the actions of a company display an employer-employee relationship, then their workers are indeed employees, regardless of how they choose to describe them.