Did you know that a contractor, a business partner, a vendor, a customer – literally anyone – can fill out a form with the IRS stating that you may be misclassifying your hired help as contractors when they should be employees?
Yikes! As if an IRS audit is bad enough, an IRS audit that comes from someone “telling on you” is worse.
As a Fractional CFO, I lift up the couch cushions of your business and take a close look at every nook and cranny where we might find loose change or a hidden issue that may cause serious financial issues with your business. Misclassification of employees is one such big issue that I can help you identify and correct. Book a meeting with me today for a consultation.
“I don’t hire employees. I hire independent contractors. It’s so much less paperwork and hassle.”
I’ve heard a variation of this statement more times than I find coins in couch cushions. And while there is truth in “less paperwork and hassle” in the short-term, trust me when I say that it is definitely not less paperwork and hassle when an IRS audit comes in with hefty fees, back-taxes owed, compounding interest, and associated legal fees.
So, what’s a business to do? Avoid the employee versus contractor business trap, and ensure you are properly classifying your hired help from the beginning. And if you are already in full-swing but think you may have a problem, it’s not too late to correct the issue.
Understanding the Difference | Employees vs. Contractors
If you are reading this hoping for a one-sentence answer to the question, “Do I need to hire an employee or a contractor?” you won’t find it here. There is no one single defining difference between an employee and contractor, as classification is situational.
Here’s what the IRS has to say:
“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.”
An employee is employed by a specific business to regularly provide services for the company and their performance is measured against the company’s set metrics. An employee can be full-time or part-time, and the business pays the employer portion of their payroll taxes (Social Security and Medicare).
A contractor is self-employed and can provide services to many different businesses simultaneously, not just yours. Contractors are often hired for projects with an end date, or can be hired for ongoing work. A contractor has to pay both employer and employee payroll taxes themselves.
3 Factors In Determining Classification
There are 3 big factors to consider when deciding if you should classify hired help as an employee or contractor. Because there isn’t a one-size-fits-all answer, it’s helpful to get out a pen and paper and take notes. Draw two columns, one labeled “employee” and one labeled “contractor.” As you review each of the following factors, put a tally under the label where your hired help fits: in the employee column or the contractor column. Then, at the end of your analysis, you can determine if your help should be classified one way or the other based on which label fits best.
- Relationship. This is the biggest consideration and the type of relationship depends upon how the hired help and employer perceive their interaction with one another. For example, if the services done are a key activity of the business (or part of the services the business provides to others), they usually fall in the employee category. If the services are to be completed by the end of a fixed time period and there is no expectation that the work will continue afterwards, they fall into a contractor category. Benefits are not offered to contractors, nor are contractors expected to complete performance reviews.
- Behavioral Control. If internal training is required to perform tasks, that is evidence for an employee not a contractor. An employee can be told when, where, and how, with incredibly detailed instructions. A contractor has agency to complete the tasks during their own hours and using their own methods. An employee can go through a performance evaluation that tracks and measures the entire process, whereas a contractor may be evaluated on whether they reached the end goal or not (but not how).
- Financial Control. Businesses cannot restrict contractors from working for other businesses. Employees are guaranteed a regular hourly, weekly, monthly, or yearly wage, while a contractor may work for a flat fee or an hourly rate for a specified amount of time. Contractors often have to go through a big process to “win” work, while an employee is given work directly from the company because it’s defined in their job description. If you make payments to a company name or an LLC entity, that points to a contractor relationship, while making payments to an individual could be an employee or a contractor.
There are a couple of other items to consider when completing your employee vs. contractor analysis:
- How did the hired help obtain the job? If through an application or resume, that points to an employee. If through a bid and proposal process, that points to a contractor. If through an employment agency, that can be either.
- Does the hired help have a job title? That is evidence of an employee.
Seeking Assistance for Employee vs Contractor Classification
If you are trying to classify your hired help correctly, but just don’t know which is correct, there are ways to seek help. First, the IRS website contains much more detail than what I’ve included in this article. Do your homework and keep making your tallies in your notebook for either employee or contractor.
If you are still unsure, the IRS offers a form that you can complete and return to them for assistance. Filing this form essentially opens up your entire business to an IRS audit, so this isn’t a popular way to go. (Note that anyone can file this form on behalf of your company, including a contractor that thinks they have been misclassified!)
If you’d prefer more personal, discrete assistance, I’m here to help! I offer financial risk mitigation that includes getting issues straightened out, educating you in best practices and procedures to prevent problems, personnel classification, and more. You don’t know what you might be missing, so allow me to help you identify issues before it’s too late. Contact me today for a consultation.