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Whether you own a business that hires people or you are a worker, either as a firm’s employee or working independently for several businesses, it’s important to be correctly classified. That’s because state and federal tax laws as well as labor regulations treat employees differently from independent contractors. We break down the differences and why they matter.

Independent Contractors vs. Employees: The Basics

If a worker is an employee, the business will withhold income, Social Security and Medicare taxes from the employee’s check. If the worker is an independent contractor, the company isn’t responsible for withholding taxes.

There are also differences in how the law treats the two categories of workers. Employment and labor laws designed to protect employees don’t apply to independent contractors.

This difference is significant for two types of businesses. The first is a business that may hire independent contractors or employees. The other is a self-employed businessperson who may be an independent contractor.

A business that may hire individuals to provide services could have either independent contractors or employees. How they are classified has a profound impact on how the business needs to work with the employees.

A self-employed individual who provides services to other businesses is likely an independent contractor. The self-employed worker is responsible for his or her own taxes, as well as benefits and other matters.

Distinguishing Independent Contractors From Employees

The usual method of solving the independent contractor vs. employee puzzle is to apply a set of tests. The exact tests that are used can vary. Besides federal tests, different states draw various distinctions between independent contractors and employees. But these are some of the most common factors:

  • Control. Does the company control or have the right to control how the worker does the work, such as hours worked? Does a manager exercise direct detailed oversight of the worker? Control is the main factor examined by the Internal Revenue Service.
  • Financial aspects. Does the company reimburse the worker for expenses? Does the company provide necessary tools, equipment and supplies?
  • Benefits. Does the company provide benefits such as paid vacation, insurance and a retirement plan?
  • Taxes. Does the company withhold taxes from the worker’s check?
  • Contracts. Is there an employment contract describing the worker as an employee?

If the answer to any of these is affirmative, then the worker is likely to be an employee. Otherwise, the worker could be a contractor. Here are other tests for contractor status:

  • Does the worker bring specialized skills or expertise to a specific project or task?
  • Did the worker already have these skills, as opposed to getting them through training provided by the business?
  • Is there a statement of work outlining specific duties and tasks the worker is to do?
  • Does the worker have many other businesses as clients?
  • Does the worker submit invoices for work completed?
  • Does the worker determine his or her own hours?
  • Is the worker responsible for paying his or her own taxes?

If the answer to any of these questions is affirmative, the worker is likely an independent contractor.

Statutory Employee

Besides employee and independent contractor, the IRS recognizes a third classification of worker, the statutory employee, a hybrid of employee and independent contractor. The IRS recognizes four types of statutory employees:

  • A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.
  • A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.
  • An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done.
  • A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments.

Form SS-8

These diagnostic tests are helpful but not always definitive. To officially establish a worker’s classification, file IRS Form SS-8. Then the IRS will do its own evaluation of the worker’s status for purposes of federal tax withholding. Caveat: The IRS process takes at least six months, so plan ahead if possible.

As noted, states get into the act as well. Since every state is likely to be different, you have to contact your own state labor office. The Department of Labor maintains an online list of state labor offices, directors, commissioners and secretaries to help with this.

The Bottom Line

It’s important for businesses to know whether people working for them are employees or independent contractors. The normal way to do this is by applying a series of tests. If you can’t make the determination, the IRS will make it for you. Getting it wrong could lead to financial penalties for failure to withhold taxes, as well as potential labor law violations.

Tips

  • Many financial advisors specialize in working with business owners. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • Calculating the pay of your employees can be a challenge. Here’s a helpful guide to getting it right.

Photo credit: ©iStock.com/miodrag ignjatovic, ©iStock.com/simon2579, ©iStock.com/photographer

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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