There are a couple of ways to see whether the people you hire are employees or contractors. What we don’t recommend: Crossing your fingers and hoping for the best, closing your eyes and pointing, or drawing straws.
Why you need to know the difference between employees and contractors
In the most famous example of its kind, Microsoft miscategorized thousands of employees over many years. In the end, the employees sued the tech giant for missed benefits, including coverage in the company's 401(k) plan and a discount stock purchase plan, for the period during which they had been miscategorized. This was after Microsoft paid back taxes and penalties. The case lasted for eight years and went all the way to the Ninth Circuit Court, which determined that Microsoft did have to pay its employees for missed benefits...to the tune of $97 million.
Don’t let this happen to you.
How to tell the difference
A lawsuit of this size happening to you is unlikely. But miscategorizing your workers can have expensive results.
If you incorrectly classify an employee as an independent contractor, you can be held liable for employment taxes for that worker, as well as penalties for failing to file those taxes in the first place.
Generally speaking, the IRS requires that you withhold taxes, including Social Security and Medicare, and pay taxes, including Social Security, Medicare, and unemployment, on wages you pay your employees. And generally, you don’t have to withhold or pay any taxes on payments to your contractors. Businesses typically don’t provide benefits to independent contractors either.
You can see how a small business could be tempted to classify all of its workers as contractors--they cost you less, maybe even if you pay them more.
The IRS uses three factors to tell whether the people working for you are employees or contractors
- Behavioral Control: Do you control how, where, and when a person does her job? If so, she’s probably an employee. If you’re only interested in the result and don’t have any say over a person’s working hours, where he works, the tools he uses, and you don’t provide training, he’s likely an independent contractor.
- Financial Control covers whether the business has a right to direct or control the financial and business aspects of the worker's job. For example, a video producer is hired to create an advertisement and he hires a freelance art director and videographer out of the budget he’s given. He’s probably a contractor.
- Type of Relationship relates to how the workers and the business owner perceive their relationship. This one is fuzzy--intentionally so. Think of this as the government’s way of asking you to use your best judgment and be reasonable. There can easily be a gray area that can make it hard to tell whether a worker is an employee or a contractor. But if you expect a worker to clock in every day at the same time, request time off rather than just letting you know, work for an indefinite period (rather than on a project-by-project basis), and use the tools of your choosing, you’re treating that person like an employee and need to classify her as such.
Even if you’re not facing gray areas, many businesses have a combination of employees and contractors, and that can make for a confusing tax-filing process. We help our clients make sense of their accounting, tax, and payroll headaches--and help them avoid costly mistakes.