Independent Contractor vs. Employee Comparison with Examples
Many employers are unclear of the difference between an independent contractor and an employee, and therefore unsure of when they should enter a new worker into their payroll system. Some employers want to see if a worker will be a good fit for their company before having to process all the new hire paperwork to get them entered into the company's payroll system. And others feel that employees who are part-time or only occasionally work for the company can be paid in cash and treated as an independent contractor. However, it's important to be as sure as possible where the distinctions lie in order to help avoid potential penalties for non-compliance.
Independent Contractor vs. Employee
The IRS doesn't have a specific checklist for determining whether a particular person is an employee or independent contractor. Instead, employers should take into account all facts and circumstances to reach a conclusion. The level of control an employer has over a worker is determinant in whether the worker will be considered an employee or an independent contractor for tax purposes. The following factors can be considered some indicators of control.
- Behavioral: Does the employer control how and when the worker does their job?
- Financial: Does the employer control when and how the employee is paid and which expenses, if any, are reimbursed by the employer?
- Relationship Type: Does the worker have a written contract or receive any type of benefits such as sick leave, paid vacation days, or health insurance? Is the relationship ongoing or finite in length?
Let's take a look at some real-world examples.
- Scenario — Susan is a high school student who works in Company A's office as a file clerk after school for about 10 hours a week. She is instructed on what work to perform and how it should be completed including use of the company’s computer. She also comes in to do some cleanup around the warehouse on weekends when needed.
Classification — The IRS would likely classify Susan as an employee. She performs her work at the company’s location, the owner tells her when to work, what to do, and she uses their equipment. The owner also controls when and how she is paid. Company A has substantive behavioral control and financial control over Susan. The owner should withhold payroll taxes and issue a Form W-2 at the end of the year for Susan if she is classified as an employee.
- Scenario — Mary works as an accountant for Company A on an as-needed basis. When the company calls her, she determines which days she works, where she works, and she uses her own equipment. She invoices the company when she is finished and she determines how and when she is paid. Mary also works for many other companies and represents herself in the public as an independent accountant.
Classification — The IRS would likely classify Mary as an Independent Contractor. She is not under any type of control by Company A. Mary will pay her own taxes during the year. If the company classifies Mary as an independent contractor, they should issue a Form 1099 to her at the end of the year.
- Scenario — Paul works 25 hours per week at Company A as a driver. He uses his own truck, but he is reimbursed for fuel costs. Paul is paid an hourly wage and is reimbursed for the cost of his lunch while on the road. Paul is eligible for coverage under the company’s health insurance plan and he receives one week of paid vacation annually. The shipping department tells Paul where and when the deliveries need to be made, so his schedule revolves around that information.
Classification — The IRS would probably classify Paul as an employee. Even though he uses his own vehicle, Company A pays his expenses while out on the road, such as lunch and fuel, and they also offer Paul the option to enroll in their health insurance plan. Even though Paul is a part-time worker and his schedule varies, it varies due to the employer's constraints and not because Paul chooses to work on certain days. Company A exercises a significant amount of behavioral control and financial control over Paul. In addition, Paul also receives some employee-type fringe benefits such as health insurance and vacation time. If Paul is classified as an employee, Company A should withhold payroll taxes on Paul and issue a Form W-2 at the end of the year.
- Scenario — Joseph is a carpenter/handyman, works for Company A when they need him, and has been doing so for 15 years. He has his own tools and is not controlled in any way as far as job performance. Company A will basically tell him what they need built or repaired and the time frame for completion. The company would reimburse him for any materials needed for the job. Joseph bills them for materials and labor at the end of the job, and lists payment terms on his invoice. Joseph also works as a handyman and carpenter for other companies as well.
Classification — The IRS would likely see Joseph as an independent contractor. Even though the company pays for materials, they do not specify when or how Joseph is to do his work, and he provides his own tools. Even though this is a long-term relationship, he works only when needed, and the company does not provide him with fringe benefits. If Joseph is classified as an independent contractor, he will be responsible for his own taxes and Company A should issue a Form 1099 to him at the end of the year.
In all, there is really no hard and fast answer for every case where there is an independent contractor vs. employee question. The IRS looks at each case independently, considering all the applicable facts and circumstances. If an employer still has questions in this area, they are encouraged to consult an HR professional, legal counsel, or request a determination from the IRS through the use of Form SS-8.
One thing employers shouldn't do is wait for the IRS to audit their workers’ classifications. The IRS can levy delinquent payroll taxes, plus penalties and interest, if they find misclassified workers that should have been classified as employees, which can be very costly. If you think you may have some misclassified workers, the IRS has a voluntary classification settlement program that might be helpful in reducing your potential liability.
The IRS voluntary classification settlement program gives taxpayers the ability to reclassify their workers as employees in future tax periods for employment tax purposes. This program relieves a portion of the employment taxes to help mitigate a potentially large payroll tax liability. The company will need to meet certain requirements, but if those requirements are met, this program can assist employers in addressing misclassified workers.