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Contractor or Employee? You Need to Know the Difference

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A contract worker can be an asset for a growing small business that isn’t ready to commit to a full-time employee. However, if the Internal Revenue Service (IRS) decides that a contractor is really an employee, that business could face a significant financial penalty.

Generally, the penalty is a percentage of the amount of Social Security and Medicare taxes that should have been withheld from the employee’s pay, says Randy Donaldson, CPA, a business consultant for the University of Georgia Small Business Development Center in Atlanta. “If there is gross negligence or fraud involved, then there would be substantial penalties, taxes and interest based on both the employer’s and employee’s Social Security and Medicare taxes,” Donaldson says.

Know the general guidelines

Although the IRS does not have hard-and-fast rules that distinguish a contractor from an employee, it does offer guidelines that can help your business avoid those penalties. These guidelines fall into three categories:

1. Behavioral control: Behavioral factors indicate whether a business has the right to direct or control how the worker performs his or her duties. For example, does the business have to give workers instructions? Does the business train them in the work it is paying them to do? “If so, it speaks to the worker being more like an employee,” Donaldson says.

2. Financial control: Financial factors indicate whether the business has the right to control the economic aspects of the work. For example, does the business pay for the worker’s tools? Are expenses reimbursed? If so, “That’s more like an employee,” Donaldson says.

3. Type of relationship: Relationship factors characterize the nature of the association between the business and the worker. For example, does the worker receive payment for services rendered, but not benefits? Does the worker have multiple employers? If so, “That leans toward a contractor,” Donaldson says.

Keep state taxation in mind

Small business owners also have to be mindful of how state taxation agencies classify contractors and employees. A state’s classification can be independent from the federal government’s classification, says Judith E. Dacey, CPA, a principal with J.D. Sumter & Associates Inc., based in The Villages, Fla.

For example, the Florida Department of Revenue, which collects unemployment taxes (referred to as reemployment in Florida), tends to lean toward classifying workers as employees, Dacey says. What often happens is once a contractor stops working at a job, he or she files for unemployment benefits. If the state decides that the contractor is really an employee and the business owner agrees to pay state unemployment taxes rather than contest it, the owner may be liable for federal taxes, as well.

“Because the cost of the state unemployment tax is generally not that high, the small business owner decides that it’s not profitable to argue this, and would just … pay it, not realizing the snowball that generally starts with the federal government,” Dacey says.

Payroll management systems are one tool that can help sort out the confusion. These systems can be offered online and automatically take care of federal, state, and local tax deposits and filings, and supply year-end W-2 forms for employees and 1099 forms for contractors.

Overall though, small business owners should just do their best to follow the IRS guidelines, Dacey says. “I suggest for everyone to be very aware of the IRS decision factors on independent contractors and employees,” she says.

For more information on the IRS guidelines, visit IRS.gov.

This content is general in nature and does not constitute legal, tax, accounting, financial or investment advice. You are encouraged to consult with competent legal, tax, accounting, financial or investment professionals based on your specific circumstances. We do not make any warranties as to accuracy or completeness of this information, do not endorse any third-party companies, products, or services described here, and take no liability for your use of this information.


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