A sticky issue for many small employers revolves around who is an employee versus who is an independent contractor.
Many smaller companies use independent contractors to keep employee expenses lower. Independent contractors are engaged for specific projects, so there are only costs to the company hiring them when there is specific work to be performed. In addition, independent contractors do not have to be covered under workers’ compensation insurance or other employee benefits, and the company does not have to pay the employer portion of Social Security and Medicare taxes.
However, the Internal Revenue Service and the courts have established strict guidelines on who can be considered a true independent contractor in recent years. This has come in large part because of employers who used the status of independent contractor on people who were really employees simply to reduce their costs by saving on benefit costs and the expense associated with the employer Social Security match. The status of independent contractor versus employee is not guided by a specific law, but by a series of court cases. There is no simple checklist, but rather a growing list of criteria that help determine independent contractor status. Therefore, a certified public accountant or an attorney should be consulted to help assure that a business is in compliance with the current interpretation of this area of tax law.
According to the Internal Revenue Service, "A general rule is that you, the payer, have the right to control or direct only the result of the work done by an independent contractor, and not the means and methods of accomplishing the result."
Additional guidelines on who can be considered an independent contractor versus an employee are as follows (from the IRS website):
- Individuals will likely be considered employees if they receive ‘extensive’ (note that the definition of this term is left up to interpretation by the IRS) instruction on:
* how, when or where to do the work they will perform
* what tools or equipment to use
* where to purchase supplies and services
- Individuals will likely be considered employees if they receive training about required procedures and methods.
- Individuals will likely be considered independent contractors if they:
* make significant investment in their work
* do not get directly reimbursed for expenses
* have the ability to make profit or loss on their work
* receive no benefits from the company, such as health insurance and paid vacation.
In the past, the IRS would allow people to be considered independent contractors if they met some portion of these rules. But over time the IRS has gotten much stricter in their interpretation. Now it is generally considered that all of the rules must be met to classify an individual as a true independent contractor and not an employee. Written contracts between the company and the individual that clearly define the relationship using the above criteria can also help support that a person is a true independent contractor.
What happens if you get this wrong? Significant interest and penalties for back taxes not paid for starters! So, again, don't try to work this all out on your own -- get help from your CPA or employment attorney.
