You start a company or your business is doing well and you want to expand; therefore, you need to hire more workers. You may have heard something about the difference between an independent contractor and an employee but the choice is pretty obvious no? Independent contractors are more flexible, cheaper, and you get to avoid the hassles of wage and hour laws. In addition, your worker has no problem with an independent contractor agreement, so why would you classify him or her as an employee? The answer is simple: the classification of this worker must be in compliance with the law; it is not up to you and the worker to choose it; and it is important to get this distinction right.
The most important IRS rule and common law doctrine to keep in mind when defining your worker is 1) the amount of control your business has over the individual-the more control your company has over the worker and how, where, and when the work is performed, the more likely he or she will be considered an employee and 2) companies, however small, are in fact being audited. So, while it may be tempting to circumvent laws associated with hiring employees (especially for foreign companies hiring independent contractors in the U.S. in a matter of minutes thanks to the internet), the risk is real and increasing.
What is the difference between an independent contractor and an employee?
In determining the status of a worker, the IRS uses eleven main tests/factors organized into three main groups: behavioral control, financial control, and the type of relationship of the parties (source: IRS Publication 15-A, 2010 Edition, page 6; available for downloading from http://www.irs.gov/pub/irs-pdf/p15a.pdf).1 Each factor is designed to evaluate who controls the work and how it is performed. No factor is determinative of an individual’s status but rather, looking at the totality of those factors and circumstances of each worker, one can make a more accurate classification.
1. Instructions the business gives the worker. The key consideration is whether the business has retained the right to control the details of a worker’s performance.
2. Extent of any training the business gives the worker.
3. The extent to which the worker has unreimbursed business expenses.
4. The extent of the worker’s investment. If the worker supplies his or her own equipment, materials and tools.
5. The extent to which the worker makes his or her services available to the relevant market.
6. Method of compensation: whether a person is on an employer’s payroll and receives a steady paycheck.
7. The extent to which the worker can realize a profit or loss.
Type of relationship
8. Written contracts describing the relationship the parties intended to create.
9. Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay.
10. The permanency of the relationship. If the worker can be discharged at any time and can choose whether or not to come to work without fear of losing employment.
11. The extent to which services performed by the worker are a key aspect of the regular business of the company.
Why the IRS and the Department of Labor care and what’s the risk?
When a worker is an employee, employers must pay state and federal unemployment tax, social security tax and workers compensation/disability premiums. When a worker is an independent contractor, the hiring party is not required to make any of these payments. For this reason, the IRS and the Department of Labor are getting more sensitive about misclassification and as a result more companies are starting to get audited regardless of their size. It is important that business owners understand that violations for misclassification can be steep. In some instances, there can be criminal charges for willful violations. Ultimately, if the IRS deems an independent contractor to be an employee, the punishment will likely require payment of a variety of fees and taxes including: FICA, federal unemployment tax, retroactive benefits, social security, and not to mention legal fees.
What about my intellectual property if the worker is an independent contractor?
At the IP level, this distinction is also important. If the person is an employee, his work, in the context of his employment, is regarded as “work made for hire.” This is an exception to the general rule that the person who creates a work is legally recognized as the author of this work.
However, many businesses which misclassify their workers (and have independent contractor agreements with workers who should be employees) omit to specify in such agreements that the work created in the name of the business and pursuant to the terms of an independent contractor
agreement is a “work for hire.” Failure to include this will result in any work created such as possibly pamphlets, trademarks, and customers lists to be the property of the worker, not the business.
The Bottom line
Know the status of your worker. An independent contractor is his or her own boss while an employee is much less independent and works within the parameters set by your business. Misclassification is a serious risk for a business of any size. Accurately classifying your worker will save you time and money in the long run.