When looking to hire new personnel, my small business clients often ask me to draft the contract between the business and the new hire. It is oftentimes not until this point that the business has examined whether the new hire is an independent contractor or employee. An agreement used for an employee will be different in many key respects than an agreement drafted for use with an independent contractor. With that in mind, the following is a summary of the key differences between an employee and an independent contractor.
Much of this information has been taken from the IRS website at www.irs.gov, which contains a wealth of information on the subject and which I highly recommend every business reads when facing this issue. Just recently, the IRS published IRS Summertime Tax Tip 2009-20, which is summarized below.
-Hiring a worker as an independent contractor instead of as an employee will generally lessen the amount of taxes a business pays, because when a worker is an employee, employers must pay state and federal unemployment tax, social security tax and workers compensation/disability premiums to a State Insurance Fund. When a worker is an independent contractor, the business is not required to withhold these taxes or make these payments. That responsibility falls on the worker.
-The IRS uses three characteristics to determine the relationship between businesses and workers: Behavioral Control, Financial Control, and the Type of Relationship.
-Behavioral Control looks at whether the business has a right to direct or control how the work is done. The more control a business can exert over the work to be performed, the more likely the worker is an employee. Conversely, the more freedom and discretion the worker has in performing the work, the more likely the worker is an independent contractor. Do not confuse this with the business’s ability to control the result of the work done, a business is always permitted to exert control over results, and such control has no bearing on the contractor/employee discussion. Rather, the IRS examines the means by which the worker does the work.
-Financial Control looks at whether the business has the right to direct or control the financial and business aspects of the worker’s job. In other words, if the worker is on an employer’s payroll and receives a steady paycheck, the likelihood increases that the worker will be deemed an employee.
-The Type of Relationship factor relates to how the workers and the business owner perceive their relationship. It should be noted that the IRS will make its determination using substance over form, meaning that while it is interested in how the relationship between the parties is perceived by the parties, the IRS will make its determination ultimately regardless of how the parties paper their relationship.
In addition to the above points, the IRS has made clear in earlier publications that the following factors will also play a role in its determination:
-Who supplies the equipment, material, tools, workstations, and other items in order for the worker to perform the job. The more materials that the business supplies, the more likely the worker is an employee.
-Who controls the worker’s hours of employment.
Many times the characterization of the relationship between a worker and a business will be easy to determine. Sometimes, however, the line between employee and independent contractor will be blurred. It is in such a situation that the above factors must be analyzed carefully so that at the outset, a well written agreement hat accurately captures the parties’ relationship can be drafted and executed by the parties.