- DETERMINING HIRING STATUS
- LEASED EMPLOYEES
- BENEFITS ELIGIBILITY AT-A-GLANCE
- FORMS AND CHECKLISTS
- Who is eligible for benefits?
- Who is an employee?
- Are there penalties for improper classification?
- What determines the employer-employee relationship?
- Are the special rules for professionals?
- How can an employer protect employment status?
- How are leased employees treated?
It is critical that business owners correctly determine whether the individuals providing services are employees or independent contractors.
The first step in determining whether an employee is entitled to company benefits is to resolve the hiring status of a new recruit. In other words, is the worker actually a company employee or an independent contractor. This distinction is important because employees will generally be entitled to participate in the company’s benefits programs, while independent contractors would not be.
From the employer’s perspective, in addition to benefits, the employer must generally withhold income taxes, withhold and pay social security and Medicare taxes, and pay unemployment tax on wages paid to an employee. An employer does not generally have to withhold or pay any taxes on payments to independent contractors.
Determining whether the new recruit is an employee or an independent contractor is crucial. The Internal Revenue Service (IRS), as well as other government agencies do not take this matter lightly, as there are many tax consequences and other legal ramifications associated with this determination.
Whatever the arrangement, the understanding should be confirmed with proper documentation. Failure to include such documentation in the files can leave a business vulnerable to challenge in the future. Such challenges are being led by the federal, state and local governments as they tap avenues for additional revenues through payroll tax deficiencies and penalties for failure to abide with employment rules.
Normally, a business is inclined to hire an independent contractor in cases when it wants to avoid the responsibilities and burdens of an employment relationship. These include payroll tax expenses, wage withholding requirements and costs associated with eligibility for other benefits packages. Such costs include pension plans, health insurance and other fringe benefits such as workers’ compensation and state requirements related to employment taxes and rules in the workplace.
From the new hire’s perspective, an independent contractor enjoys freedom from “control” and the opportunity to take advantage of the ability to deduct business-related expenses directly on their personal tax return.
Employees or Independent Contractors
Before you can determine how to treat payments you make for services, you must first know the business relationship that exists between you and the person performing the services. The person performing the services may be –
An Small Business Tax Resources (common-law employee)
In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.
Given that the law does not provide a specific definition of “who is an employee,” a worker is deemed to be an “employee” based on the common law rules, statutory definitions or specific tests, that have developed as a result of historical case law.
An “employer-employee” relationship exits when an employer has the right to:
- Control and direct what work is to be done;
- Control and direct how the work is to be done and provide the details and means to fulfill the tasks and responsibilities; and
- Control and direct when the work is to be done.
However, certain workers can be held to be employees regardless of the common law tests described below. Certain workers enjoy relief from “employee” status if they are deemed to be “statutory independent contractors.” Moreover, relief from employment taxes is possible if a worker is not treated as an employee for a period of time and a reasonable basis exists not to do so.
The IRS has established a 20-factor control test to determine whether a worker is an employee or independent contractor under the common law definition. The list is merely a guideline and is not all-inclusive. If these factors are present, the IRS will presume the worker to be an employee of the employer.
Common Law Rules
Facts that provide evidence of the degree of control and independence fall into three categories:
Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.
The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.
Independent Contractor Defined
People such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public are generally independent contractors.
However, whether these people are independent contractors or employees depends on the facts in each case. 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 and not what will be done and how it will be done. The earnings of a person who is working as an independent contractor are subject to Self-Employment Tax.
Facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties as shown below.
Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of–
Instructions the business gives the worker. An employee is generally subject to the business’ instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work:
- When and where to do the work
- What tools or equipment to use
- What workers to hire or to assist with the work
- Where to purchase supplies and services
- What work must be performed by a specified individual
- What order or sequence to follow
The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker’s performance or instead has given up that right.
Training the business gives the worker. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.
Facts that show whether the business has a right to control the business aspects of the worker’s job include:
The extent to which the worker has unreimbursed business expenses: Â Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services they perform for their business.
The extent of the worker’s investment: An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.
The extent to which the worker makes services available to the relevant market: An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.
How the business pays the worker: An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.
The extent to which the worker can realize a profit or loss: An independent contractor can make a profit or loss.
Type of Relationship
Facts that show the parties’ type of relationship include:
- Written contracts describing the relationship the parties intended to create.
- Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay.
- The permanency of the relationship. If you engage 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 your intent was to create an employer-employee relationship.
- The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of your regular business activity, it is more likely that you will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.
If you want the IRS to determine whether a worker is an employee, file Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS.
The following examples may help you properly classify your workers.
- Building / Construction
- Professional Fields
Building and Construction Industry
Example 1. Jerry Jones has an agreement with Wilma White to supervise the remodeling of her house. She did not advance funds to help him carry on the work. She makes direct payments to the suppliers for all necessary materials. She carries liability and workers’ compensation insurance covering Jerry and others he engaged to assist him. She pays them an hourly rate and exercises almost constant supervision over the work. Jerry is not free to transfer his assistants to other jobs. He may not work on other jobs while working for Wilma. He assumes no responsibility to complete the work and will incur no contractual liability if he fails to do so. He and his assistants perform personal services for hourly wages. They are employees of Wilma White.
Example 2. Milton Manning, an experienced tile setter, orally agreed with a corporation to perform full-time services at construction sites. He uses his own tools and performs services in the order designated by the corporation and according to its specifications. The corporation supplies all materials, makes frequent inspections of his work, pays him on a piecework basis, and carries workers’ compensation insurance on him. He does not have a place of business or hold himself out to perform similar services for others. Either party can end the services at any time. Milton Manning is an employee of the corporation.
Example 3. Wallace Black agreed with the Sawdust Co. to supply the construction labor for a group of houses. The company agreed to pay all construction costs. However, he supplies all the tools and equipment. He performs personal services as a carpenter and mechanic for an hourly wage. He also acts as superintendent and foreman and engages other individuals to assist him. The company has the right to select, approve, or discharge any helper. A company representative makes frequent inspections of the construction site. When a house is finished, Wallace is paid a certain percentage of its costs. He is not responsible for faults, defects of construction, or wasteful operation. At the end of each week, he presents the company with a statement of the amount he has spent, including the payroll. The company gives him a check for that amount from which he pays the assistants, although he is not personally liable for their wages. Wallace Black and his assistants are employees of the Sawdust Co.
Example 4. Bill Plum contracted with Elm Corporation to complete the roofing on a housing complex. A signed contract established a flat amount for the services rendered by Bill Plum. Bill is a licensed roofer and carries workers’ compensation and liability insurance under the business name, Plum Roofing. He hires his own roofers who are treated as employees for Federal employment tax purposes. If there is a problem with the roofing work, Plum Roofing is responsible for paying for any repairs. Bill Plum, doing business as Plum Roofing, is an independent contractor.
Example 5. Vera Elm, an electrician, submitted a job estimate to a housing complex for electrical work at $16 per hour for 400 hours. She is to receive $1,280 every 2 weeks for the next 10 weeks. This is not considered payment by the hour. Even if she works more or less than 400 hours to complete the work, Vera Elm will receive $6,400. She also performs additional electrical installations under contracts with other companies, which she obtained through advertisements. Vera is an independent contractor.
Example 1. Rose Trucking contracts to deliver material for Forest Inc. at $140 per ton. Rose Trucking is not paid for any articles that are not delivered. At times, Jan Rose, who operates as Rose Trucking, may also lease another truck and engage a driver to complete the contract. All operating expenses, including insurance coverage, are paid by Jan Rose. All equipment is owned or rented by Jan, and she is responsible for all maintenance. None of the drivers are provided by Forest Inc. Jan Rose, operating as Rose Trucking, is an independent contractor.
Example 1. Steve Smith, a computer programmer, is laid off when Megabyte Inc. downsizes. Megabyte agrees to pay Steve a flat amount to complete a one-time project to create a certain product. It is not clear how long it will take to complete the project, and Steve is not guaranteed any minimum payment for the hours spent on the program. Megabyte provides Steve with no instructions beyond the specifications for the product itself. Steve and Megabyte have a written contract, which provides that Steve is considered to be an independent contractor, is required to pay Federal and state taxes, and receives no benefits from Megabyte. Megabyte will file a Form 1099-MISC. Steve does the work on a new high-end computer which cost him $7,000. Steve works at home and is not expected or allowed to attend meetings of the software development group. Steve is an independent contractor.
Example 1. Donna Lee is a salesperson employed on a full-time basis by Bob Blue, an auto dealer. She works 6 days a week and is on duty in Bob’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 Bob. Bob also pays the cost of health insurance and group-term life insurance for Donna. Donna is an employee of Bob Blue.
Example 2. Sam Sparks performs auto repair services in the repair department of an auto sales company. He works regular hours and is paid on a percentage basis. He has no investment in the repair department. The sales company supplies all facilities, repair parts, and supplies; issues instructions on the amounts to be charged, parts to be used, and the time for completion of each job; and checks all estimates and repair orders. Sam is an employee of the sales company.
Example 3. An auto sales agency furnishes space for Helen Bach to perform auto repair services. She provides her own tools, equipment, and supplies. She seeks out business from insurance adjusters and other individuals and does all the body and paint work that comes to the agency. She hires and discharges her own helpers, determines her own and her helpers’ working hours, quotes prices for repair work, makes all necessary adjustments, assumes all losses from uncollectible accounts, and receives, as compensation for her services, a large percentage of the gross collections from the auto repair shop. Helen is an independent contractor and the helpers are her employees.
Example 1. Donna Yuma is a sole practitioner who rents office space and pays for the following items: telephone, computer, on-line legal research linkup, fax machine, and photocopier. Donna buys office supplies and pays bar dues and membership dues for three other professional organizations. Donna has a part-time receptionist who also does the bookkeeping. She pays the receptionist, withholds and pays Federal and state employment taxes, and files a Form W-2 each year. For the past 2 years, Donna has had only three clients, corporations with which there have been longstanding relationships. Donna charges the corporations an hourly rate for her services, sending monthly bills detailing the work performed for the prior month. The bills include charges for long distance calls, on-line research time, fax charges, photocopies, postage, and travel, costs for which the corporations have agreed to reimburse her. Donna is an independent contractor.
Example 1. Tom Spruce rents a cab from Taft Cab Co. for $150 per day. He pays the costs of maintaining and operating the cab. Tom Spruce keeps all fares he receives from customers. Although he receives the benefit of Taft’s two-way radio communication equipment, dispatcher, and advertising, these items benefit both Taft and Tom Spruce. Tom Spruce is an independent contractor.
The business cost of hiring employees generally exceeds the cost of using independent contractors. But, this statement must be prefaced by the assumption that based on the facts and circumstances, the taxing authorities cannot assert that an “employee” status exists. Should a taxing authority successfully argue that “employee” status exists, the penalties can be extensive.
Consequences of Treating an Employee as an Independent Contractor
If you classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker
Leasing is different from the more common practice of hiring temporary employees through employment agencies. Such employees (often called “temps”) are generally engaged for brief periods, during peak business periods or as fill-ins for employees who are on vacation, etc. Leased employees are often retained for longer periods of time.
In a leasing arrangement, an employer typically contracts with an unrelated company (the “leasing” company)â€”often called a Professional Employer Organization, or PEOâ€”to provide (all of the) support services for the business. Since the workers are considered employees of the leasing company, they need not be included in the employerâ€™s benefits or retirement plans. This arrangement also frees the employer from payroll functions, including payroll withholding taxes and other requirements.
To head off the potential for abuse, the law places limitations on such leasing relationships. If an individual serves as a â€œleased employeeâ€ for a business for a period of at least one year on substantially a full-time basis, the worker may be treated as an employee of the company for which the services were performed.
The IRS and the DOL are very suspicious of these types of arrangements, and will look to the relationship between the employer and the worker and the nature of the services performed, to determine whether they are of the type normally rendered by employees. And, if it finds that to be the case, it will treat the worker as an employee of the recipient company for purposes of income tax withholding, retirement and benefit plan participation requirements, life insurance, cafeteria plans and other employee benefits.
Remember, employers are ultimately responsible for the payment of income tax withheld and both the employer and employee portions of social security and Medicare taxes.Â
Outsourcing payroll duties can be a sound business practice, but know your tax responsibilities as an employer!
Many employers outsource some of their payroll and related tax duties to third-party payroll service providers. They can help assure filing deadlines and deposit requirements are met and greatly streamline business operations.
Employers who outsource some or all of their payroll responsibilities should consider many factors, including the fact that employers are ultimately responsible for the payment of income tax withheld and both the employer and employee portions of social security and Medicare taxes.
- Determining whether a new worker is an employee or an independent contractor is crucial.
- Whatever the arrangement, the understanding should be confirmed with proper documentation.
- The business cost of hiring employees generally exceeds the cost of using independent contractors.
- Penalties can be assessed for the improper classification of an independent contractor.
- The IRS has established a 20-factor control test to determine whether a worker is an employee or independent contractor.
- The law allows a measure of relief, in that it permits an employer to treat certain common law employees as independent contractors.
- A business can protect the understanding that an individual is an independent contractor by having the individual sign an “independent contractor agreement.”
- Leasing employees is becoming increasingly popular, as employers are struggling to keep benefits and payroll costs down.
- Independent Contractor Determination Form
- Independent Contractor Agreement
- Acknowledgment Form for Temporary and Leased Employees