Scenario 1 - Scott Kiley hires Liz Baker to work as his website designer. Liz will design and program the company's website by December 1, and be paid upon completion of the project. Should the project not meet Scott's satisfaction, Liz will not be paid for the work completed.
Scenario 2 - Don Ivanhoe hires Sam Heller as his bookkeeper. Sam works 20 hours a week in Don's office and 20 hours a week from home. Sam is reimbursed for all materials used to complete work at home and is paid on a monthly basis. Sam is also entitled to receive health benefits after 30 successful days with Don's company.
Which one of these professionals is the employee and which one is the independent contractor? How can you tell?
Every time you hire someone to work for you, you need to ask yourself if the person is an employee or an independent contractor. There is a difference and it's not just in the name. Taxes and IRS penalties can be a prominent issue if you misclassify a professional and proceed as such.
What's the main difference between independent contractors and employees?
While employees pay income tax, Social Security, and Medicare, their employers are responsible for paying a portion of Social Security and Medicare, as well as all of the unemployment and worker's compensation insurance premiums. Independent contractors, on the other hand, are responsible for paying 100 percent of their own taxes.
How can you tell if the person working for you is an independent contractor or an employee?
The determination of whether a person working for you is an independent contractor or an employee deals centrally around the degree of control and independence given to the worker.
The IRS breaks down the issue of degree of control and independence into three categories - behavioral control, financial control, and the type of relationship between the parties.
Behavioral control relates to the employer's right to control how the professional completes his or her work, including the instructions and training given to the professional. Typically, employees are told when, where, how, and with what to do the work. On the other hand, independent contractors have autonomy in deciding when, where, and how to complete the work. Whereas employees may be asked to complete their work in a certain order from 9:00 a.m. to 5:00 p.m., an independent contractor may complete his/her work at any time during the day, so long as he/she completes the assignment in accordance with the terms agreed upon. Also, employees typically receive job-specific training related to their tasks, whereas independent contractors are expected to begin the assignment with knowledge in tow.
The issue of financial control deals with the business operation of the professional, including investment and expenses. While employees typically see the bulk of their expenses reimbursed, independent contractors are responsible for paying all business-related expenses. An independent contractor often invests a great deal into his/her business for equipment, marketing, and facilities, whereas an employee is not required to make similar purchases, as they are either not necessary or provided by the employer.
Financial control also deals with the ability of the professional to make his/her services available to the general public, how payment is made, and profit and loss. Independent contractors are free to solicit additional work; employees are typically restricted to working solely for their employer. While employees receive payment for their work in regular intervals, independent contractors are typically paid by the project. Lastly, the issue of profit and loss asks if the person working can realize a profit or loss as a result of his/her work. A person working as an employee does not typically feel the fluctuations associated with changing market demand or have those fluctuations affect his/her overall success. However, an independent contractors entire livelihood is dependent on market demand and can vary greatly depending on project work.
Type of relationship deals with the defined and applied relationship between the employer and the professional. On the defined side, this deals with whether the professional was labeled an employee or independent contractor in contract documentation. In agreements or contracts, employees should be clearly defined as employees, while independent contractors should be defined as independent contractors.
Type of relationship also includes the issue of relationship permanence and the reliance on the professional by the employer. The employee's job is critical to the operation of the business as the employer and his/her business are dependent on the skills provided on a continual basis. Typical independent contractor/employer relationships are not permanent in nature but project-based. Independent contractors general provide a few services to the company on a defined basis. Their job, while required, is not critical to the operation of the business on a continuing basis.
Famous cases of worker misclassification
The Microsoft Corporation carried out the most famous case of employee misclassification in the late 1980s. Microsoft hired a subset of professionals to function as writers, software testers, and formatters. Upon hiring, Microsoft classified each professional as an independent contractor and had them sign an agreement stating they independent contractors and, as such, not entitled to the benefits offered to its employees.
Unfortunately, Microsoft's mistake was that, despite its attempt to brand these professionals as independent contractors, they neglected to treat them as independent contractors. Rather, these professionals were subjected to many of the same requirements as regular employees.
One of the mistakes Microsoft made regarding these professionals was in dictating the manner and means by which they worked. Whereas employees are typically bound to perform a job in the manner indicated by his/her supervisor, at the location requested, and within a strict set of parameters, independent contractors are not bound by such rules. Though they may be hired to complete a certain task, the independent contractor has the right to determine where, when, and how the task will be completed. In addition to following rules set down by Microsoft supervisors, working onsite, and performing their job in the same manner as the regular employees, the professionals designated as independent contractors were also misclassified when they were given access to company equipment and supplies. While employees are generally given the materials needed to get the job done, independent contractors are responsible for providing their own equipment.
When the IRS conducted an audit of Microsoft's payroll accounts, it discovered Microsoft's error and stated that Microsoft was responsible for paying back taxes on all misclassified employees. In addition, the Ninth Circuit Court of Appeals found that Microsoft was responsible for paying the back benefits of eight employees who filed suit, including health benefits, 401(k), and stock option plan coverage.
This blunder by one of the largest and most widely respected organizations in the country details the importance of correctly classifying the people you hire. Though Microsoft defined the type of relationship with the professionals, it failed to treat them as independent contractors in terms of behavior and financial control. Employers who misclassify personnel could be responsible for back taxes and penalties on employees mislabeled as independent contractors, including unemployment compensation and corporate benefits, such as health care coverage and vacation time.
Conclusion
The most important thing that you can do when hiring someone, is to understand what relationship this person will have with your organization. Will they be an employee or an independent contractor?
The chart below can help sort out the questions you have about a professional's status.
| |
EMPLOYEE |
IC |
| Are you withholding income tax, Social Security, and Medicare? |
Yes |
No |
| Are you paying Social Security, Medicare, Unemployment, and Worker's Comp? |
Yes |
No |
| Is this person entitled to benefits? |
Yes |
No |
| Do you control the person's work habits, i.e. time, place, method, and tools? |
Yes |
No |
| Have you provided training for the assignment? |
Yes |
No |
| Are you reimbursing expenses incurred as a result of work? |
Yes |
No |
| Do you provide the equipment and materials needed to complete the job? |
Yes |
No |
| Do you allow the person to market his/her services to other firms? |
No |
Yes |
| Does this person realize a profit or loss as a result of his/her work? |
No |
Yes |
| Is the relationship with this person defined as permanent or continuing? |
Yes |
No |
| Is his/her role critical to the continuing operation of the business? |
Yes |
No |
Remember Liz and Sam from the beginning of the article? Using the information given, can you tell who is the employee and who is the independent contractor?
Because of Liz's relationship with Scott for only the duration of the web design project, her project-based payment, and the potential for Liz to lose money for unsatisfactory completion, Liz would be classified as an independent contractor.
Because of the continual nature of Sam's work as a bookkeeper, his monthly payment, the fact that he is reimbursed for business expenses, and his ability to receive health benefits, Sam would be classified as an employee.
* For legal purposes, the term, Independent Contractor (IC), is used in place of the Guru.com term, Freelancer.
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