Independent Contractor or Employee: Why It Matters to the IRS

Are you using independent contractors to handle extra work in your business instead of going through the hassle of hiring permanent employees? It's a smart move, but one that can also lead to tax troubles if you classify these workers incorrectly and the IRS finds out about it.

Hiring independent contractors can give small business owners access to skills and experience they might otherwise not be able to afford, or workers they can't find in the local area. When you work with independent contractors, you don't have to pay for their employee benefits, pay unemployment taxes or withhold Medicare and Social Security taxes. All of this saves you time, headaches and money.

However, if you treat your independent contractor like an employee, the IRS may rule that the person should have been classified as an employee all along. Then you may face penalties and have to pay back employment taxes on the independent contractor’s wages.

How do you know if you’re classifying a worker correctly? The IRS looks at three different aspects of the control that you have over the worker.

1. Behavioral control: How much control do you have over the way the person does the job? Do you provide training, require the person to use certain equipment, or control the hours he or she works?
2. Financial control: How involved are you in the worker’s finances? Do you pay him or her a salary, or do you pay by the hour or the project? Does your business reimburse the worker for business expenses, pay for his or her equipment, or provide a workspace?
3. Relationship: You might be considered to have an employer-employee relationship if you provide the person with benefits such as health insurance or a retirement plan, if the relationship is long-term or permanent (as opposed to ending when the project ends), or if the work the person does for you is essential to your core business.

All three of these factors must be considered in determining what category a worker falls into; none has more weight than any other. In general, the less control you have over the person, the more likely they are to truly be considered an independent contractor.

In most cases, a worker’s status is pretty easy to determine, but sometimes it's more difficult.  This 20-question test from the IRS can help you pinpoint how a worker should be classified. You can also read Publication 1779, Independent Contractor or Employee. If you still can't figure it out, ask your accountant for help. You can also file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS and have them make the determination for you.