Independent Contractor Versus Employee: Nailing Down the Distinction

Author: Adam Wren Date: March 24, 2011

Small Business and Independent Contractors

Should you classify someone who works for your small business as an employee or independent contractor?

That question can be among the trickiest you’ll face as a small business owner. And arriving at a wrong answer—in the eyes of the IRS, at least—could bring your business to its knees. An estimated several million workers are misclassified by up to 30 percent of U.S. employers, according to the National Employment Law Project, and worker misclassification carries with it costly fines, back taxes and interest payments.

What’s the difference? Broadly, according to the IRS, employers are required to withhold taxes and pay Social Security, Medicare and unemployment tax on wages paid to an employee. Not so with an independent contractor.

But deciding what’s best for your business can be a long and difficult process, says Amy Lynn Keimach, owner of Border7 Studios, a small design firm in Simi Valley, Calif.

In 2005, when Keimach launched Border7, she began with a fleet of independent contractors. “But they were more of employees based on law, so we ended up switching,” Keimach says. In 2010, after doing a lot of financial projections, she switched her team over to employees because her forecasting revealed that she could afford the increased cost of associated taxes and benefits.

But a year later, she has settled on a hybrid model. Of Border7’s 10 employees, Keimach now classifies four—all designers—as independent contractors. "They have the option to work wherever, whenever," Keimach says.

That freedom is one of the main distinctions between the two classifications, says Neil Johnson, a CPA and small business tax expert with The Dolans Group in Northbrook, Ill. Worker classification is usually determined by the amount of control the company has over how the individual works, he says.

Johnson points those small business owners he advises to a few simple tests to determine whether a worker is a contractor or employee. A worker is generally considered an employee if you: 

  • Set office hours or a fixed daily schedule
  • Provide the worker with a space to work, a computer or business cards
  • Offer the worker a retirement plan or health benefits

In more complicated situations, Johnson refers his clients to the IRS’s SS-8 form, which walks owners through a few dozen questions to help them determine how to accurately classify their workers.

The bottom line: “If you’re a business owner, you don’t want the IRS to come in and reclassify the worker,” Johnson says. “Getting this wrong really has some significant costs to the business owner,” because it’s not just the taxes you’ll have to pay the IRS, it’s the penalties and interest, he says.

Above all, seek outside legal advice when making the initial decision and throughout the employment/contractor relationship when circumstances change.

Aggravated by the hassle? NFIB has long sought to simplify the test to identify independent contractors, so let your lawmakers know that the IRS's current complex test creates extra paperwork and expense for your business.

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