Your ‘Contractor’ Might Be an Employee

Posted on December 19, 2014 in Employee Issues

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The amount of control you have over your workers affects their legal definition.

Entrepreneurs continually face an age-old conundrum: You can’t grow your company without hiring more people. But you can’t hire anyone until the company has grown enough to afford employees. That’s why independent contractors are often an attractive option.

They save business owners the burden of paying health insurance premiums, payroll taxes and other benefits that can increase an employee’s total compensation package by as much as 30 percent. And when business slows, you have no under-producing employees on the payroll to support.

But you have to be careful about the independent contractors you choose and how you use them, particularly if your contractor is an individual and not a corporation or LLC. That’s because, from a legal perspective (and in the view of the IRS), some “contractors” may be part-time employees in disguise.

“Fred” found this out the hard way. He hired Emily, an aspiring actress, to handle his bookkeeping once a week. They agreed she would be paid as a “1099” independent contractor. When Emily repeatedly missed days because of auditions, Fred fired her. Emily filed for unemployment benefits, which Fred disputed. The unemployment board took the position that Emily was, in fact, a part-time employee: She performed bookkeeping work only for Fred, worked at Fred’s office on Fred’s equipment, and had no separate overhead and no investment capital at risk. As a result, Fred was stuck paying not only the unemployment insurance benefits, but also penalties and interest for not having done so in a timely fashion.

Luckily for you, there are ways to research your workers’ true legal definition before you turn out like Fred.

A Question of Control
The law looks at the degree of control you have over the person you hired. The more control you exert, the more likely your worker will be deemed an employee and not an independent contractor, regardless of the label you place on the working relationship or the title you have on any written agreement. The IRS has identified 20 elements (known as the “20 Factor Test”) it considers in determining whether an individual is truly an employee or an independent contractor. However, the factors can be distilled into the following three categories:

  1. Behavioral control exists when your company has the right to direct or control how the worker performs the work. Do you give extensive instructions and training to the worker? Do you determine where the worker will perform the services? Do you decide what the worker will do and when? Do you provide the equipment, supplies or other required materials to complete the work? Do you provide staffing for the work with assistants of your own choosing? The more you answer “yes,” the more likely it is that you are hiring an employee.
  2. Financial control is apparent when your company has the right to direct or control the business aspects of the work. Has the worker made her own financial investment in her business? Does she pay for some or all business expenses, such as rent and utilities, licensing and professional dues or advertising expenses? Does the worker take a risk on the transaction by realizing a profit or incurring a loss? If the answer is “yes” to these criteria, the scales tip to the independent contractor side.
  1. Relationship control depends on the way you perceive your association with the worker. Do you provide benefits, such as insurance, pension or paid vacation? Do you make payments for the worker’s services to an individual instead of a corporation? A “yes” answer may tip the scales to “employee” if it is difficult to determine status based on other facts.

In close cases, governmental entities will usually classify a worker as an employee unless you can show otherwise. So be wary of treating a worker as an independent contractor. Be sure to review your situation with legal counsel to ensure that you make the right choice.

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