Getting to the point where you are ready to hire some help in your business can be very exciting {and nerve-racking}. When you bring on someone else, you open yourself to a whole new set of issues you didn’t really have to consider before. There will be many logistical things you will have to figure out as you transition from solopreneur to having a team. But, one of the most important things to consider is whether you are hiring an independent contractor or employee.
You may think if you call your new team member an “independent contractor”, that’s what they are. But, as you’ll find when you read on, it’s a bit more complicated than that. And, deciding incorrectly could have been severe ramifications later. This article will point out the key differences between independent contractors and employees and how you can know what type of help you are hiring.
why does it matter?
Whether you are hiring an independent contractor or employee is important for three main reasons.
1. Taxes
When you have “employees”, you are expected to withhold certain federal/state taxes. Then, you will take that money withheld and submit it to the government. Generally speaking, “independent contractors” are responsible for their own taxes and all you are required to do is pay them. They are in charge of paying the correct amount of income taxes to the government.
2. Workers’ Compensation
Most states require businesses to have some kind of workers’ compensation plan when they have employees. If an employee gets injured on the job, they may apply for these workers’ compensation benefits. If you only have independent contractors, then generally, they are responsible for their own insurance and what would happen to them/their income if they got injured on the job.
3. Other employment issues
There are other employment issues that can come up. The one that seems to come up most often is what happens if a third party is injured by your worker while they are doing work for you. If you have an employee, you are likely going to be responsible for the actions of that person while they are doing work for you. However, if your worker is an independent contractor, then they are likely to be held personally {or their business} responsible for any damages or injuries that may occur while they are doing their work.
Keep in mind, it’s not always the IRS who is going out to find misclassified workers. These issues often come up in third-party lawsuits, when a worker is injured, and/or when someone, whether it’s a customer or the worker, decides to alert the IRS to your alleged misclassification.
what is an independent contractor?
An independent contractor is someone you hire to do work for you, but that is not hired on as a member of your staff. Independent contractors are becoming more and more popular as workers are starting to piece together different jobs to make an income.
You manage your relationship with an independent contractor through a contract, usually called Independent Contractor Agreement. This agreement lays out what you and the worker agree to do, what the expectations are, timeframes, pay, etc.
what is an employee?
An employee is someone you hire to be a dedicated worker for your business. Typically, this comes with a certain amount of hours on a certain schedule. As an employee, the worker has taxes withheld from their paycheck and may be eligible for certain employment related benefits.
For an employee, you will need a written employment agreement with them. This can be included with a handbook, but can also be a separate document. Your agreement with an employee will need to be more detailed than an independent contractor, because you will have more responsibilities to them and they will probably have more responsibilities to you and your company than an independent contractor.
how do you know?
IRS’s 3-prong test
The IRS has developed a 3-prong test to determine whether someone is an employee or independent contractor.
1. Behavioral
This prong includes things like: how much training and/or instruction the person received from the company doing the hiring, whether services are personally rendered, whether the work be delegated to another party, the hiring, supervising and/or paying of assistants, whether there is a continuing relationship between the parties, set hours of work, how many hours worked, where the work is completed, and how the work is done.
The more control the hiring party has over these aspects of the person’s work, the more likely they are to be considered an employee as opposed to an independent contractor.
2. financial
This prong includes the financial aspects of the relationship between the parties. This includes things like how & when payments are made, what expenses are paid for or by the worker, what tools and/or materials are provided by the hiring company, which party takes the profit/loss that results from the work being done, etc.
If the worker is paid on a regular schedule, is reimbursed for expenses, is provided with the tools & materials necessary to complete the work, and/or the company is the one to take the profit/loss as a result of the work, the worker is more likely to be considered an employee as opposed to independent contractor.
3. type of relationship
This prong looks at the relationship between the parties and covers things like whether the worker can do work for other companies, whether the worker’s services are an integral part of the company’s business, whether the worker is available to the general public, and how termination of the worker takes place.
Generally, an independent contractor is available to do whatever kind of work they do to whomever they want to do it for. The worker is more likely to be considered an employee if the company wants to control this aspect of the worker’s services.
State laws
In addition to the IRS’s 3-prong test, many states have adopted a version of the following workers’ compensation test for an independent contractor:
- Maintain a separate business
- Maintain an FEIN
- Operate under specific contracts
- Incur operating expenses
- Responsible for satisfactory performance
- Compensated for contract
- Subject to profit/loss of the contract
- Recurring business liabilities and obligations
Under this test, the worker must satisfy all the prongs to be considered an independent contractor.
Making a correct determination on whether someone you hire is an employee or independent contractor can have big consequences for your business in the future. A written agreement is not the deciding factor in the classification, but having a clear agreement between you and whomever you hire can go a long way towards classifying those who work for you correctly.
Disclaimer: This site, and all information contained herein or through communication with me, is intended as legal information only. I am an attorney, but I am not your attorney, so nothing on this site, nor any communication with me, shall create an attorney-client relationship. I am not liable for damages or losses based on any action taken, or inaction, based on the information contained on this site. All areas of the law are fact specific and there is no substitute for legal advice from an attorney licensed in your jurisdiction who is familiar with the specific facts and circumstances of your situation.