When to Hire a Contractor versus an Employee

By Tammy Swasey-Ballou | Jan 02, 2013

Understanding the distinction between the tax and legal consequences of hiring a contractor or an employee can save your company money and avoid costly mistakes.

Here is the IRS description of an Employee:

Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Employee-(Common-Law-Employee)

And here is the IRS description of a Contractor:

People such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public are generally independent contractors. However, whether these people are independent contractors or employees depends on the facts in each case. The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-Defined

On the same webpage, a caution is given:

“You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed.”

LegalZoom discusses the Fair Labor Standards Act:

“In an attempt to interpret provisions of the Fair Labor Standards Act and discern between employee and independent contractor status, some courts and federal agencies have come up with the "economic realities test." It looks at the dependence of the worker on the business for which he or she works. If a person gains a large portion of their salary from that business, chances are that person qualifies as an employee.”

http://www.legalzoom.com/everyday-law/workplace/employee-vs-independent-contractor-differences

The U.S. Small Business Administration discusses the implications of misclassification:

“Misclassification of an individual as an independent contractor may have a number of costly legal consequences.

If your independent contractor is discovered to meet the legal definition of an employee, you may be required to:

  • Reimburse them for wages you should've paid them under the Fair Labor Standards Act, including overtime and minimum wage
  • Pay back taxes and penalties for federal and state income taxes, Social Security, Medicare and unemployment
  • Pay any misclassified injured employees workers' compensation benefits
  • Provide employee benefits, including health insurance, retirement, etc.”

http://www.sba.gov/content/independent-contractors-vs-employees

According to federal and state court cases, here are the questions you should ask as a business owner to determine the status of the labor you will be hiring:

  1. Is the worker an integral part of the business?
  2. Is the worker doing business exclusively with your business or are they offering services to multiple clients?
  3. Is there a degree of permanence to the workers relationship with your business?

If the answer is:  this person does periodic projects with minimal supervision that are not critical to the mission of your business, then you have an independent contractor on your hands. If the answer is:  this person works regular weekly hours with regular communication in a critical area of your business, then you have hired an employee.

Finally, if this worker relies on your business as a primary source of income and has given up certain rights to independence to conform to the needs of your business, be sure to properly categorize this employee and provide the proper documentation and benefits to avoid costly penalties. Independent contractors enjoy minimal oversight as they complete individual projects for multiple clients and give up certain tax shelters to enjoy greater independence.

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