Classifying workers appropriately is important for your financials.
Is Your Worker an Independent Contractor or an Employee?
Most general contractors and subcontractors will run into this situation at some point in their careers – is your new worker an independent contractor or an employee? Well, luckily for those who find themselves in this situation, the IRS has created a simple “test” to answer just that question.
This test helps classify the individuals who work for your business and determine if their role should be that of an employee or an independent contractor. Often, we jump to the conclusion that we should treat our newest hand as an independent contractor, especially if they’re providing a specific skill or trade.
However, this test will show that this is often not the case. It’s critical to understand the distinction between independent contractor and employee as this classification will determine how you perform certain business procedures throughout the year (taxes, payroll, worker’s compensation, forms, etc.).
The IRS designed their test to evaluate the range of control you have over the worker, and conversely, their range of independence from you. Through three main categories, you’ll be able to determine if a worker is indeed an independent contractor (non-employee). Those categories are Behavioral Control, Financial Control, and Type of Relationship.
This first test really comes down to how much control you have over a worker when they’re performing the duties of a job or project. An independent contractor demands very little to absolutely no supervision. It would be typical for them to understand the scope of their job and know how to execute it. An employee, on the other hand, relies on your direction. This means you can determine when, where and how they perform their work. This includes specifying which tools you prefer for each job, what time of day you want certain work done, in what order you want tasks completed, and more.
Training to some capacity is often a necessary part of onboarding an employee so they’re familiar with your working process. An independent contractor, however, would come well-equipped with their skill set. They have an understanding of how to work their contribution into the larger picture without training.
In the construction industry, a large part of the Financial Control test focuses on how your worker gets paid. Often, independent contractors are paid in one lump sum. This is based on a bid that was made and agreed upon before the job began. In some instances, an independent contractor may also work for hourly pay during a period agreed upon in a contract.
On the other hand, employers pay out employees routinely through a pre-established payroll arrangement. This means they’re filling out W2s and paying taxes and social security with each check they receive from your company. Your company is obligated to withhold of state and federal taxes for each employee. An independent contractor would end the job with you without paying any of these fees. Instead, they’d settle-up quarterly or at year’s end with their 1099.
In addition to method of payment, the IRS also offers explanation on categories such as un-reimbursed expenses, significant investment, opportunity for profit or loss, and services available to the market. Unclear about how your worker fits the financial control test? Refer to the IRS link at the bottom of the post.
Type of Relationship
The type of relationship between employer and worker is the third and final category in the independent contractor test. First, the contract with your worker should specify whether you intend to treat them as an independent contract or an employee. It’s wise to follow the best practices of using contracts in all your business arrangements. You’ll also want to address benefits. Is your worker receiving insurance, paid time off, sick leave or other company allotted perks? You’ll probably want to classify them as an employee. Likewise, an indefinite working time frame is evidence for an employer-employee relationship.
Finally, think about whether your worker is expected to do key activities for your business. If so, the IRS assumes that the business owner would have a say in the direction and process of that work. This would also lean the worker toward classification as an employee.
It’s more common than not for general contractors to try to establish all of their workers as independent contractors. This simplifies bookkeeping and eliminates payment of worker’s compensation insurance. In general, it reduces the burden of having employees.
However, once put to the IRS Independent Contractor test, many of these independent contractor relationships would be considered employee relationships. This misclassification can lead to tax penalties and other headaches if the IRS or your state’s employment division get wind of your operating practices. While the issue may never come up, one angry subcontractor or disgruntled prior employee can lead to an investigation with poor results for you and your business.
It’s a smart idea to do your due diligence and properly classify your workers from the beginning. This will protect your business from a tax-heavy surprise at the end of the year. What if it turns out your independent contractor should have been classified as an employee? Well, you’ll be paying all those taxes and fees in bulk at tax time – in addition to what your business may owe. This creates a chaotic situation and can upset your books and back office management.
For a comprehensive list of all twenty factors the IRS uses to determine worker classification status, click here.
Ready to set your workers up as employees and on payroll? We can help!