John Day

Article Summary:

Understanding the difference between a contractor vs an employee.

Contractor Vs Employee

An Independent Contractor (IC) is an individual who contracts with a business entity to perform a service independent of the entity’s management. The contractor is not considered an employee and therefore, is responsible for his own taxes.

If you are in business now or planning to be, there is a good chance that you will have to deal with the issue of Independent Contractor (IC) vs. Employee either sooner or later. The business community and the IRS have been playing a cat and mouse game around this subject for many years. The reasons are clear. Businesses can save money by hiring an IC because they are not responsible for collecting and paying any taxes. In addition, they can hire this “expert” to come in and complete a specific job. This means they don’t have to train their own employees and keep them on the payroll when the job is done. This can be a great solution for employers whose staffing demands fluxuate with the workload. Since these are non-employees they are not entitled to any company benefit programs. You can see why businesses are looking for these cost saving opportunities.

The Internal Revenue Service (IRS) sees nothing wrong with hiring IC’s as long as they are legitimate IC’s. Therein lies the rub – in many cases it is not a clear black vs. white situation. The lay of the land can become fuzzy and gray. In an attempt to remedy the ambiguities, the courts and the IRS have developed a set of twenty factors or questions that an employer or worker can use to determine IC status. You can find these factors on the Internet by typing the keywords “Independent Contractor – Twenty Criteria". However, there are no fixed rules or regulations that stipulate which factor or combination of factors must be met in order to be classified as an employee or an IC. Each case is evaluated on its own facts, many in front of a jury.

The risks of hiring an IC depend on the situation. Many small businesses hire someone as an IC to determine whether they want to hire that person full time as an employee. The IRS would frown on this approach, but the risk is minimal if it is a low paying job and the IC status doesn’t last long. The risk is that the employer will become responsible for the employment taxes of the worker if recharacterized from IC to employee. This includes penalties and interest for failure to pay these taxes, and for failure to file the payroll tax returns. It is also important to keep in mind that if the state you live in has income and payroll taxes you could be assessed for those taxes, plus penalties and interest. The federal taxing authorities normally communicate with their colleagues at the state level.

Usually, the feds won’t go back further than three years due to the statute of limitations, however, if you have several workers making good money that are recharacterized, you could be faced with a huge liability. I have personally seen two small companies have to go out of business as a result of these types of audits. You may find some relief if you can locate your IC workers and get them to prove that they paid their taxes. Any assessed tax to you cannot be recovered from the worker.

It could get worse if you have a retirement plan in place. The plan could be retroactively disqualified which could cause all vested accrued benefits to become fully taxable for employees enrolled in the plan.

Whenever a business hires an IC, the first thing to do is have the individual sign a W-9 form. This should be done before any work is started. This is the due diligence form where the worker is verifying that his/her address and social security number are correct. Without this form, the business can be fined $50 if this information turns out to be incorrect.

Next, try to comply with as many of the twenty factors, mentioned above, as possible. Even by following all these measures, the IRS still may not agree with you. You have to keep in mind that the deck is stacked in favor of the IRS and their tendency, in gray areas, is to rule in favor of employee status. Why? It is because they have the opportunity to collect more money, which, believe it or not, happens to be the guiding principle of the IRS.

John W. Day, MBA is the author of two courses in accounting basics: Real Life Accounting for Non-Accountants (20-hr online) and The HEART of Accounting (4-hr PDF). Visit his website to download for FREE his 3 e-books pertaining to small business accounting and his monthly newsletter on accounting issues. Ask John questions directly on his Accounting for Non-Accountants blog.

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