The Importance of Properly Classifying Independent Contractors

Many businesses use independent contractors—such as salespeople, writers, accountants and others—to more effectively carry out the company’s mission. The benefits of using an independent contractor vs. hiring an employee include less overall cost, more flexibility and less liability exposure. 

However, there are significant consequences if the government discovers you are erroneously treating an employee as an independent contractor. You will need to (1) reimburse the employee for wages you should have paid, including overtime and minimum wage; (2) pay back taxes and penalties for income taxes, Social Security, Medicare and unemployment; (3) pay an injured employee workers' compensation; and (4) provide benefits, including health insurance and retirement.  
So how do you know if you are properly classifying a worker as an employee vs. an independent contractor? Many groups—including the IRS, the Department of Labor (who issued the Fair Labor Standards Act in 2009), and the Supreme Court—have weighed in on the definition. For tax purposes, the IRS applies a 3-part test to the working relationship that covers behavior, finances and type of relationship. While there’s no singular standard for what differentiates an employee from an independent contractor, employers should ask themselves these questions: 

• Does the worker set his/her own hours?
• Does the worker use his/her own tools?
• Does the worker have his/her own office or workspace at the company?
• Can the person work for other employers?
• Who makes the rules for how and where the work will be done?
• How permanent is the relationship?
• To what degree does the worker assume profit and loss?    

After answering these questions, if you are still uncertain as to a worker’s status, the IRS recommends filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. The IRS will then review and make a determination.