Employee vs. Contractor

Small businesses may at times mistake the subtle differences that exist between an employee and a contractor. This can be a confusing process of determination and a costly mistake to make. Proper classification maintains one’s good standing with the IRS, reduces administrative expenses, as well as group insurance rates and social security. While many believe the understand the difference and feel they have a safeguard through good faith or such misunderstandings as commission based pay, a legal battle with the IRS is never worth taking the time to properly understand the standards by which these workers are judged to be an employee or contractor.

The IRS maintains a list of guidelines by which it judges a worker to be an employee or contractor. This list of guidelines was issued in 1996 and has been used to gauge the general disposition of the worker rather than a strict list of criteria.

This list revolves around the concept of control of the worker. For example, where an employee would receive instruction from the employer – the employer having control over how the worker performs their duty – the contractor would receive little to no instruction of how the work was performed. Additionally, an employee would surrender control to the employer of where and when the work was performed, whereas contractors would maintain this decision-making power. The IRS has thus defined control as:

Anyone who performs services is an employee if you, as an employer, can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the legal right to control the method and result of the services.

The list of guidelines the IRS uses to gauge a worker’s disposition is based upon common law factors. These factors are:

  • Instructions
  • Training
  • Integration
  • Service rendered personally
  • Hiring, supervising, and paying assistants
  • Continuing relationship
  • Set work hours
  • Requisite full-time work
  • Work is performed on owner’s premises
  • Work is accomplished in a special sequence
  • Submission of reports
  • Payment method
  • Expense reimbursement
  • Furnishment of necessary tools and materials
  • Significant investment
  • Realization of profit or loss
  • Work performed for one business entity at a time
  • Services offered to general public
  • Right to discharge
  • Right to terminate

Under the IRS guidelines, a worker is an employee if the preceding qualifications are met. These guidelines may be better understood when phrased within a realistic context. According to these guidelines, a worker is an employee if:

  • The worker receives instruction regarding where, when, and how the work is performed
  • The worker receives employer provided training
  • Overall business performance is dependent upon the worker
  • A continuing relationship exists between the worker and the company
  • The services rendered by the worker must inherently be rendered by him/her
  • There exists a predetermined set of hours in which the work is to be performed
  • The worker provides the aforementioned services on the employer’s premises
  • Pay is surrendered hourly, weekly, or monthly
  • Necessary tools and materials are provided by the employer
  • The worker may be fired without violation of a contract
  • The worker may quit without the incursion of liability
  • The worker does not provide these services to the greater public
  • The worker has no direct access to profit or loss resulting from the services provided
  • The worker maintains no significant investment within the business
  • The worker is required to proffer oral or written reports
  • The worker is a corporate officer

There do exist what are commonly referred to as ‘Safe-Harbor Rules’ which have previously shielded a company from audit and forced reclassification, and the penalties thereof. These so-called ‘Safe-Harbor Rules’ have not always protected a company, but may be implemented under particular circumstances. If applied properly, they do guard against IRS audits of worker classification.

Generally, if the worker was consistently treated as a contractor within full compliance (filing Form 1099), and the company could reliably lean upon one of three justifications for maintaining a worker as a contractor (1. Judicial precedent, 2. Past IRS audit, or 3. Industry practice), then the IRS could not dictate a re-classification.

As was previsouly stated, these ‘Safe-Harbor Rules’ are not a reliable guard against IRS audits and it is advised that a business consult an expert to verify their accordance with the law.