“What’s in a name?” asks Juliet—and so should business owners. Does it matter what you call an individual working for you? Though a rose might smell as sweet by any other name, not all labels are equal to the IRS. How you refer to your workers should accurately reflect your relationship with them, including how much responsibility you have for their taxes.
The Basics: Employees vs. Independent Contractors
Protecting yourself from liability and treating your workers fairly begins with understanding the difference between employees and independent contractors, but it doesn’t end there. Most people know to uphold minimum wage with, apply overtime provisions to, and pay over and withhold relevant taxes from employees. But who exactly counts as an employee? Since writing one off as an “independent contractor” can have financial and legal consequences, it’s important to make sure you grasp the official differences between the two.
Armed with this knowledge, you can start discerning special cases, such as when you should treat an independent contractor as an employee or, sometimes, a nonemployee.
Common law dictates that anyone who works for you and whose work you have a right to control is your employee—no matter what you call them. ¹ There is no single litmus test to determine whether a worker is an employee, which the Fair Labor Standards Act defines as someone “economically dependent on the business of the employer, regardless of skill level”. ²
Of course, you can give an employee freedom, but they remain an employee so long as you retain the right to take that freedom away. A manager you don’t need to supervise and a part-time secretary whose work you dictate daily are equal, as far as employer-employee relationship status is concerned. An employer has the power to require a person to work or prevent them from working. Employees include individuals you lease out to clients and whose payment you control.
Having employees generally entails withholding and paying income, social security, Medicare, and unemployment taxes on any wages you give them.
While your right to behavioral and financial control marks the relationship between you and an employee, independence from your control marks the relationship between you and a contractor. Independent contractors are essentially people who get work done, for you and for others, in whatever way they want. Ultimately, they work for themselves; they are not economically dependent. In the words of the IRS, when it comes to contractors, you “have the right to control or direct only the result of the work and not the means and methods of accomplishing the result” (2014 Employer’s Supplemental Tax Guide 15-A).
There’s usually no need to withhold or pay federal taxes on payments to an independent contractor.
Common Differences Between Employees & Independent Contractors
In certain cases, an employee or independent contractor, as defined by common law, may be treated as something other for employment tax purposes. Statues have been written to address these particular situations.
A contractor may become a statutory employee if they are personally performing all the services themselves, don’t own the equipment or place they’re using, and work for you regularly. They must also be either a delivery driver (of a particular type), a full-time life insurance sales agent, someone who works at home according to your instructions and with your materials, or a full-time salesperson who sells your goods to other businesses.
You should withhold Social Security and Medicare taxes—but not federal income tax—from statutory employees.
Three jobs do not fall cleanly into the employee or independent contractor categories. Though they might be working within an organization, the people in these jobs are usually considered self-employed for all federal tax purposes.
Direct sellers and licensed real estate agents are statutory nonemployees if their pay is related to performance rather than hours on the job, and if they agree by written contract not to be treated as employees for tax purposes. Companion sitters are usually considered statutory nonemployees, unless they work for a companion sitting placement service responsible for paying their wages.
Direct sellers, real estate agents, and sitters who meet these requirements are considered self-employed. If you hire them, you don’t need to withhold or pay over any federal taxes on their fees.
Consequences of Misclassification
What happens if you classify an employee as an independent contractor? First, unless you have a good reason for doing so and have filed the appropriate returns, you are liable for their employment taxes. Secondly, you could be denying the worker benefits they need and deserve. Finally, Social Security, Medicare, state unemployment insurance and workers compensation funds, as well as the Treasury, all suffer.
The distinction between employee and independent contractor—and between contractor and nonemployee or statutory employee—is as important as it is nuanced. We’re always here to help you make this important case-by-case distinction.
The Deerfield Team
- Department of the Treasury: Internal Revenue Service. “Publication 15-A: Employer’s Supplemental Tax Guide for use in 2014”. Accessed September 2014. http://www.irs.gov/pub/irs-pdf/p15a.pdf
- Department of Labor: Wage and Hour Division (WHD). “Fact Sheet 13,” revised May 2014. http://www.dol.gov/whd/regs/compliance/whdfs13.pdf