Do You Have Employees or Independent Contractors?
Updated: May 17, 2020
When you are building your business, how you classify your workers has risks. If they are classified as employees, your business must pay payroll taxes on their wages. You also might be required to obtain workers' compensation insurance, with the premium being calculated based on the size of your payroll. I have observed that companies in some industries (e.g., IT support, software, construction) prefer to classify their workers as independent contractors (or subcontractors) so they don't need to pay payroll taxes or workers' comp insurance premiums. A business can suffer some significant financial consequences, however, if it gets the worker classification wrong, including the payment of back taxes, penalties, and interest and increased insurance premiums.
Having a written contract indicating that a worker is an independent contractor does not control the classification. In other words, saying that a worker is an independent contractor does not mean that the worker is an independent contractor, even if both the business and the worker agree on that classification in a contract. Instead, the IRS will look at all the facts.
The IRS has published guidance on how to determine whether a worker is an employee or an independent contractor. You can find that guidance here: https://www.irs.gov/newsroom/understanding-employee-vs-contractor-designation.
This guidance can help you make your own determination for each worker. The IRS's general rule is that if you can control or direct only the result of the work, not what will be done and how it will be done, then your worker probably is an independent contractor. The IRS breaks down that determination by looking at the behavioral and financial control the business exerts over the worker and the relationship between the business and the worker.
For example, if the business gives detailed instructions about how to do the work (or when and where to do the work) and provides periodic or ongoing training about procedures and methods, the worker looks more like an employee. If the business buys the worker's tools and equipment, reimburses the worker for its expenses, restricts the worker from providing the same services to other businesses or the worker's own customers, and pays the worker a regular, guaranteed wage, the worker looks more like an employee. And if the business doesn't use a written independent contractor agreement, provides benefits to the worker (e.g., insurance, paid vacation, sick pay, and retirement), retains the worker for an indefinite period (rather than on a project-by-project basis), and uses the worker to provide the business's key services, the worker looks more like an employee.
Note that the IRS does not consider its guidance to be a checklist or scorecard to be used to make the worker classification by tallying the number of checked boxes to determine whether a threshold has been reached. Instead, the IRS weighs the facts related to the worker's situation to determine whether a reasonable basis exists for classifying a worker as an independent contractor.