Small Business 101: Employees vs. Independent Contractors
When you are a freelancer or a small business owner, it is imperative for your to understand your rights and obligations under the law for employment. While requirements might change in certain scenarios, there are important factors that you should know. Employers sometimes knowingly, or unknowingly, take advantage of their workers by misclassifying them. This is something I have encountered in the sports and entertainment world quite frequently.
There are some stark differences between an employee and an independent contractor.
Employees: the company generally withholds income tax, Social Security, and Medicare from wages paid.
Independent contractor: the company generally does not withhold taxes and thus the independent contractor is responsible for playing these from wages.
As 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, not what will be done and how it will be done. Small businesses should consider all evidence of the degree of control and independence in the employer/worker relationship. Whether a worker is an independent contractor or employee depends on the facts in each situation.
There is no one determining factor to decide whether a worker is an independent contractor or an employee. However, the totality of the circumstances are important and the more factors pointing toward one classification or the other, the stronger that worker or employer’s case may be in determining the status of the worker.
There are three categories that are considered when determining the proper classification of workers:
Behavioral Control
Financial Control
Relationship of the Parties
Behavioral Control:
How does the employer direct or control the worker?
If the employer has the right to direct and control the worker, then a worker is an employee. The business does not have to actually direct or control the way the work is done, but rather only has to have the right to direct and control the work.
The behavioral control factors fall into the following categories:
Type of instructions given: if the worker is told when, where, and how to work, they are likely to be employees.
Degree of instruction: the more detailed the instructions, the more likely the worker is an employee.
Evaluation systems: if the evaluation system measures the details of how the work is performed, then this points to the worker being an employee. If however, the evaluation is only concerned with the end result, this could point to either worker classification.
Training: if training is provided to the worker then the employer wants the work done in a particular way and this points to employee status.
Financial Control
Does the business have the right to control the economic aspects of the worker’s job?
The financial control factors fall into the following categories:
Significant investment: independent contractors often have a significant investment in the equipment they use to perform services. However, a significant investment in and of itself does not determine worker status.
Unreimbursed expenses: independent contractors are more likely to have unreimbursed expenses than are employees, but employees are also able to have unreimbursed expenses.
Opportunity for profit or loss: the higher the possibility of incurring a loss the more likely the worker is an independent contractor.
Services available to the market: independent contractors are generally free to seek out additional opportunities while concurrently being under contract with another company for services.
Method of payment: an employee is generally guaranteed a regular wage. An independent contractor is usually paid by a flat fee for the job or an hourly wage predicated on a non-guaranteed number of hours worked.
How do the worker and the business perceive their relationship?
The factors, for the type of relationship between two parties, generally fall into these categories:
Written contracts: contracts aren’t fully determinative of worker status.
The IRS is not required to follow a contract stating that the worker is an independent contractor. How the parties work together determines whether the worker is an employee or an independent contractor.
Employee benefits: generally employees are paid benefits such as health insurance, 401K, paid vacation, and the like. However, the lack of these benefits does not always mean the worker is an independent contractor.
Permanency of the relationship: the more permanent the relationship between the worker and business, the more likely the worker is an employee. If the worker is only hired for a specific project or period, that generally indicates an independent contractor relationship.
Services provided as key activity of the business: if the worker provides key services for the functioning of the business, it is more likely that the business will have the right to direct and control those activities, thus the worker is probably an employee.
Classifying an employee as an independent contractor with no reasonable basis for doing so makes employers liable for employment taxes. Certain employers that can provide a reasonable basis for not treating a worker as an employee may have the opportunity to avoid paying employment taxes.
I have worked with professional athletes and freelancers who have probably been misclassified by their employers. The employers probably misclassified their workers in order to avoid paying employment taxes. If you think this might be the case for you, fill out Form 8919 on the IRS website.
This form will help figure and report your share of the uncollected social security and Medicare taxes due on your compensation, if you were an employee but were treated as an independent contractor by your employer.
While misclassification might not seem like a big deal, it can have huge ramifications for both the worker and the business. Misclassifying workers can be tricky business and can rob some workers of rights they have under the law. Be sure to categorize your workers correctly and be sure the business hiring you is classifying you correctly. You will be glad you did when tax season rolls around.
If you want help growing and building your business or brand the right way, then schedule a strategy session with Your Potential for Everything.
*Disclaimer: This is not legal advice and is for educational purposes only. If you have questions about your specific legal situation, please contact a licensed attorney in your state.*